Commentaries

Time to junk AIG

The federal government’s $180 billion effort to prop up American International Group has worked, averting an even bigger financial catastrophe. Now it’s time for the Obama administration to oversee the dismantling of the failed insurance giant with all due speed.

A report this week from the Government Accountability Office makes clear that AIG would crumble and likely reignite financial fears around the world without the government’s massive support.

And the report says it’s “unclear” whether AIG will ever pay back the $121 billion in government assistance that’s still coursing through its balance sheet.

The GAO report should provide the administration will all the ammunition it needs to get tough with AIG. The report’s conclusions should stiffen the spine of regulators in their dealings with Robert Benmosche, AIG’s new $9 million chief executive.

The former MetLife chief executive seems to act as if he has taken over a financial company that’s simply made one or two bad decisions — not one that nearly brought the global economy to its knees.

Benmosche’s plan to take his sweet time in selling off AIG’s assets might make sense if the insurer could someday stand on its own without the government’s help.

But the GAO report raises serious doubt about whether AIG will ever be self-sufficient again, noting that “the company continues to rely heavily on the federal government as its source of liquidity and capital.”

What did rating agencies know about AIG?

It’s time to start asking the big credit rating agencies just when they realized that American International Group might pose a systemic risk to the global financial system.

And what, if anything, did the rating agencies do to warn financial regulators of the global crisis that might ensue, if AIG’s debt ratings were suddenly slashed.

There’s been a lot of attention paid to the role the credit agencies played in the build-up to the financial crisis by slapping triple A ratings on complex securities built from mortgages to subprime borrowers.

But there’s not been enough scrutiny into the behind-the-scenes work the credit rating agencies did last summer as Lehman Brothers lurched toward bankruptcy and AIG’s cash crunch grew increasingly grave.

By virtue of their status as Nationally Recognized Statistical Rating Organizations, the major credit agencies are charged with making sure companies that sell bonds are able to make good on their obligations. Some 30 years ago, securities regulators effectively deputized Moody’s Investors Service, Standard & Poor’s and Fitch Ratings as gatekeepers for the financial system.

And with that lofty and privileged status, there should come a responsibility to help regulators keep an eye out for systemic financial risk.

“We rely on our gatekeepers to help insure that financial markets are safe and information is accurate,” says law professor Frank Partnoy.

Why banks should welcome “living wills”

A year after Lehman Brothers collapsed, policymakers are still getting to grips with the key question raised by the Wall Street firm’s fall: how to ensure that the failure of a large bank does not jeopardise the entire financial system.

After much debate, politicians and central bankers are warming to the idea that banks should make preparations for their own failure. This plan — memorably dubbed a “living will” by Mervyn King, governor of the Bank of England — would allow regulators to wind down even large, cross-border institutions without putting public money at risk.

Alistair Darling, Britain’s chancellor, wants to introduce legislation this autumn to force banks to draw up living wills. Such plans have drawn predictable squeals from bank executives, who claim the idea is hard to implement for large cross-border groups. They have a point. Nevertheless, bankers should embrace the idea, for the simple reason that it is better than any of the alternatives.

The status quo is no longer acceptable, so policymakers have three choices for dealing with large, systemically important financial institutions. The first is to make them smaller so that the collapse of any one bank would no longer threaten the system. The second option is to take a “zero failure” approach to regulation, along the lines of safety rules in the airline industry.

Both of these approaches have flaws. Small banks still pose a risk if they all collapse together. And preventing failures entirely would require a level of regulation that would stifle innovation and further reduce competition in financial services.

By contrast, a system of living wills would be far less intrusive. This is not to suggest the switch would be straightforward. Differences in national insolvency laws mean it is currently impossible to establish a consistent approach to winding up complex cross-border institutions. Politicians’ desire to protect local depositors and taxpayers — often at the expense of foreigners — also complicates matters. Simplifying corporate structures that have evolved over decades will also not be easy.

And even assuming that all these problems can be overcome, governments would still struggle to convince investors that they were really willing to use their powers.

Lehman tales

Over the past two days, we’ve been treated to two long stories in The New York Times and The Wall Street Journal focusing on employees of Lehman Brothers, one year after the firm’s chaotic bankruptcy filing. Yawn.

Now, don’t get me wrong–both stories are well reported and well written.  I was glad to see that one of the people the Times did a mini-profile on was a former Lehman banker who packaged and sold rotting mortgages and is honest enough to admit he has “blood on my hands.”

But it’s not the Lehman employees I’m really concerned about–even if some of them are feeling remorse now. I’m more concerned about average Americans–and for that matter, average people around the globe–who were impacted by the collapse of Lehman and the collateral damage to the financial system.

A year later, we still don’t read or hear enough stories about the average folks who bought Lehman’s now worthless structured notes, which were pitched as conservative investments. Over the past five years, a Lehman subsidiary in Amsterdam sold some $30 billion of these notes to average investors–many of them retirees–in England, Belgium, Germany, Switzerland and elsewhere in Europe.

How are these people getting on?

Or what about the thousands of people in Thailand and Asia who bought similarly worthless Lehman mini-bonds?

And let’s remember, this crisis began long before Lehman with the meltdown in the housing market. The foreclosure crisis is still going on and it’s getting worse.

from Rolfe Winkler:

A year after Lehman, the good news

Regular readers know how pessimistic I am about the economy. The "recovery" is little more than a government-financed credit bubble and it's back to risky business as usual for much of the banking sector.

But that doesn't mean there isn't good news to report.

For instance, less credit coursing through the economy means deflation, and deflation means stuff is cheaper.

Start with the cost of necessities, like shelter. House prices are down 31 percent, according to the latest Case-Shiller data.

That may wreak havoc with bank balance sheets, but it's great for buyers. Rents are down, too. I was thrilled to get two months free when I signed my new lease. Such terms were unimaginable just two years ago.

Energy isn't cheap, but thanks to reduced demand it's cheaper. Oil is down to around $70 per barrel after reaching $147 14 months ago.

Deflation can improve an economy's competitive position, too. In the short run, it means higher unemployment, but in the long run it means improved productivity.

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.

Trash is king as Lehman shares surge

It’s either a sign of sheer boredom on Wall Street, or an early celebration of the one-year anniversary of Lehman Brothers’ demise, but shares of the fallen invesment bank were red hot today.

The stock rose some 200%. Take that AIG.

For some inexplicable reason, shares of the bankrupt investment bank, which trade on the loosely regulated over-the-counter Pink Sheets, changed hands some 73 million times on Friday. That’s a lot of trading in a stock that’s been worthless for nearly 12 months.

Indeed, on a typical day, the average trading volume in Lehman shares is about 2.6 million. The last time Lehman’s stock came anywhere close to today’s trading volume was way back in October, about a month after the Wall Street firm filed for bankruptcy.

Then again, today’s trading surge boosted Lehman’s closing stock price to 15 cents. It had been sitting around 5 cents for months. Better yet, Lehman now has a respectable market cap of $103 million–not too shabby for a small-cap company on the Pink Sheets.

Of course, this trading in Lehman is just crazy. There’s not good explanation for it. Just as there is no good explanation for the big surge in shares of American International Group.

Maybe this is just a case of traders trading trash financials to score a quick profit because they can’t find anything else to trade.

Bob Diamond in the red

Just how profitable is Barclays Capital?

At first glance, the answer would be: very.  According to Barclays’ results, Bob Diamond’s investment banking empire made a £1bn profit in the first six months of the year, double last year’s figure. That’s despite continuing hefty write-downs on toxic assets.

Indeed, as other parts of Barclays succumb to the economic downturn, Barcap, buoyed by last autumn’s acquisition of the North American operations of Lehman Brothers, more or less appears to be keeping the bank afloat.

So it was with some surprise that, ploughing through Barclays’ 124-page announcement, I came across the following on page 75:

Barclays Capital economic profit increased 11% (£12m) to a loss of £94m (2008: loss of £106m), due to a 100% increase in profit before tax driven by a very strong performance in the underlying business offset by a 104% increase in the economic capital charge reflecting an increase in economic capital allocation due to market volatility, an increase in the economic allocation for monoline exposures and further downgrades across credit markets, securitisations and loan exposures.

A little background: economic profit is an internal measure used by Barclays’ top brass to calculate the profitability of its divisions while taking into account the capital they consume. It is used when considering future investments and -crucially – when calculating bonuses.

What has happened is that Barclays has doubled its internal capital allocation for Barcap. As a result, the investment bank did not earn its cost of capital in the first six months of the year.

Lehman D-Day

It’s taken awhile, but a deadline for filing claims in the Lehman Brothers bankruptcy has finally been set and it’s Sept. 22.

A Sept. 15 deadline, the one-year anniversary of Lehman’s collapse, would have been more appropriate. But maybe that would have just been rubbing everyone’s face in it.

If nothing else, the claims deadline won’t get in the way of all those obligatory Lehman bankruptcy anniversary stories that every news media outlet, including Reuters, will publish.

Even before the deadline, claims from the tens of thousands of Lehman creditor have been steadily filing in. The claims filed in the case can be found on the public docket for the Lehman bankruptcy.

Actually, the Sept. 22 deadline isn’t a hard and fast deadline. Any derivatives counterparty of Lehman has an additional month to file a claim. That’s because any creditor claiming a loss on a derivatives trade must also fill out a lenghty questionnaire.

In the end, the issue of how to resolve some 700,000 busted derivatives trades will be the thorniest matter before the bankruptcy court.

Investor protection, Singapore style

Who needs a whole new government agency to protect  consumers from irresponsible banks? Authorities in Singapore have taken a refreshingly straightforward approach in tackling banks deemed to have been less than scrupulous when selling structured notes dragged down by the failure of Lehman Brothers: they banned them.

The Monetary Authority of Singapore on Wednesday banned 10 banks from selling structured notes until they can prove that they have improved processes to highlight the risks involved. Banks including DBS and ABN Amro, now part of Britain’s Royal Bank of Scotland, are out of the business for at least six months. Hong Leong Finance receivd a two-year ban. (The full list is here.)

The so-called Lehman Minibonds are one of the many scandals triggered by the Wall Street investment bank’s collapse. They were sold as bonds that offered principal protection and an attractive rate of interest. In fact, they were complex structures supported by synthetic CDOs with Lehman acting as a swap counterparty. When Lehman filed for bankruptcy, the notes collapsed.

The MAS report is fairly dry, but nonetheless it is fairly clear that banks either didn’t understand the risks of what they were selling, or failed to tell their clients.

Some of the specific failings highlighted by the MAS include:

a) risk ratings assigned by some financial institutions to some series of the Notes that were inconsistent with risk warnings stated in the prospectus and pricing statement;

b) insufficient steps taken by some financial institutions to ensure that all their financial advisory representatives were properly trained before marketing and selling the Notes; and

c) weaknesses in how some financial institutions ensured that their financial advisory representatives were properly equipped with accurate and complete information about the Notes.

This is some consolation for the 7,000-odd Singaporean investors who lost money on the notes. Though 67 per cent of investors have received compensation, they have got just 30 per cent of their money back.