Felix Salmon

Bank debt-for-equity swaps: Where do you draw the line?

Felix Salmon
Apr 30, 2009 01:21 UTC

David Leonhardt seems to be on roughly the same page as me when it comes to debt-for-equity swaps at America’s banks:

In February, the Treasury began twisting the arms of some holders of Citigroup preferred stock to get them to convert it into common stock. (Preferred stock, despite its name, is something between a loan and stock.) The credit markets hiccupped, but quickly returned to their previous state. In the wake of the stress tests, the Fed and the administration may well push for more conversions along these lines.

The trickier issue is what to do with holders of so-called subordinate debt. In the spectrum of investments, subordinate debt is considered safer than preferred stock and tends to be subject to haircuts only when a company slides toward bankruptcy. Pushing a bank to the brink of bankruptcy would raise the specter of Lehman Brothers.

What Leonhardt doesn’t say, but leaves implicit, is that if you’re this nervous about touching the sub debt, then that means there’s no question of touching the senior unsecured debt — let alone depositors. This could be the beginning of a consensus: when a bank needs more recapitalization than the government has money to provide, then it’s certainly OK to convert preferred stock to equity (we’ve already seen that, at Citigroup), and in extremis one can convert sub debt to equity as well. But we’d be getting far ahead of ourselves if we started talking about tapping senior unsecured debt — which is banks’ chief wholesale funding mechanism.

After all, there’s no point in solving the solvency problem in the banking sector if you don’t solve the liquidity problem as well — which means that banks need to continue to have the ability to fund themselves in the private markets. If you start touching the senior debt too often — as we did in the cases of Lehman Brothers and WaMu — then even healthy banks’ ability to fund themselves rapidly disappears.


I think you are conflating capital and funding. “Senior Debt” is I think usually a form of capital and relevant to solvency, vide WaMu, ranking behind depositors (although ahead of most other forms of capital). When banks talk of funding and liquidity, it is commonly either about deposits or about inter-bank lending which ranks with deposits.

As noted by Linus Wilson, the government lacks powers to discriminate in some things. In a serious situation it is left with intervention by the FDIC. If the best route then is sale as a going concern, this seems to mean that the senior debt is at risk. And the degree of risk is partly a function of regulators’ behavior from time to time, a kind of risk that market professionals are typically not keen to take.

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Ken Lewis: Halfway out

Felix Salmon
Apr 29, 2009 22:04 UTC

I’m very glad that after the literally ridiculous performance he put on today, BofA’s Ken Lewis has been stripped of his job as chairman. Annual meetings are largely theatre, of course: the important votes have all been cast long before the meeting takes place. But with Lewis still saying with a straight face that the acquisitions of both Countrywide and Merrill Lynch were a really good idea, I can’t see how the principle of shareholders (as opposed to the CEO) electing the chairman could really survive Lewis’s re-election.

For the time being, Lewis remains as CEO, but that’s up to the board, which presumably now will take succession planning much more seriously than it has done hereunto. If and when a viable candidate for CEO emerges, I doubt Lewis will stay in charge for long.


From Wikipedia re the China melamine baby milk scandal.
“On 22 January 2009 Tian was sentenced to life imprisonment, while other Sanlu executives received sentences of five to fifteen years. Two other men were sentenced to death.”
I guess some “Masters of the Universe” are glad they are in the USA.
Another competitive advantage for China when too much power brings too much corruption ?

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Eli Broad’s art model

Felix Salmon
Apr 29, 2009 19:50 UTC

I had a brief conversation with Eli Broad at the Milken Global Conference, and asked him about my idea that his foundation is well placed to be a home to many different art collections, not just his own.

Broad first explained his art-lending policy: if a museum wants any work of art in his collection, they can have it for as long as they like, so long as they have it on show. But if they take it down for any reason other than on-lending or restoration — if they feel like just putting it in storage for an indefinite amount of time — then Broad will ask for it back.

Would Broad accept a bequest of art from another collector? Yes: “If it’s worked that fit,” he said, “we’d love to have it, lend it, pay for the insurance” and generally add it to the collection. He has a staff doing all that already, and if collectors didn’t feel like reinventing the model themselves, they could outsource it to the Broad Foundation, just like Warren Buffett outsourced his philanthropy to the Gates Foundation.

As for the art market, Broad said that “a big bubble was created, and we’re in the midst of a major correction. It was up 500%, it’s now up 250%, it could fall further.” He seemed to think that the Old Master arbitrage made sense: “Why should Richard Prince sell for more than a great Old Master? Because people don’t want to have on Old Master on their walls.”

I’m sympathetic. But at the same time, Prince is an interesting example to use, since he’s so clearly bubblicious. Broad told me that a Nurse painting which sold for $8 million a year or so ago would be worth $2.5 million now, and I suspect that you can extrapolate that decline pretty much all the way to zero. People might not particularly want to have an Old Master on their walls, but there could easily come a time, in the none too distant future, when absolutely no one has any desire to have a massive joke painting on their walls, either: it would just look dated and embarrassing. Now’s a bad time to sell a Richard Prince, to be sure. But it might well be better, financially speaking, to sell the painting now, when it’s “merely” at parity with an Old Master, rather than to have any hope that it will soar to multiples of Old Master prices ever again. Because that, frankly, seems improbable.


I would not have a Richard Prince in my collection. some are interesting, but not that interesting. My art is an accumulation, not a collection about my life exploring art and reflects my long term visual interests. the financial aspect is Peripheral to my pleasure in owning and living with my art. This is probably why i do not have big investment art nor do i need it. Most of my art has appreciated. it is part of art history.

There are collections that not promoted. Shouldn’t we be discover why they exist and what art they collect? what value they have and how it holds up.

Good and great art will always prevail. As one of my clients, I have 2) said. I am a value advisor. He undrstands that better tha i do.

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The problems of financial illiteracy

Felix Salmon
Apr 29, 2009 18:34 UTC

I was keen to go to the panel on financial literacy, which was moderated by John Bryant, the founder of Operation HOPE and a member of the U.S. President’s Advisory Council on Financial Literacy. He’s clearly committed to this cause, and is doing a very good job of picking the low-hanging fruit: in some areas, for instance, only 25% of people eligible for the Earned Income Tax Credit actually claim it. Since it can be claimed going back three years, and since it can amount to $4,000 per year, families earning less than $40,000 a year can end up with a $12,000 windfall just as a result of some simple outreach and basic education. In many cases that’s “more money in many cases than they’ll ever see in their life,” said Bryant; “it’s transformational”.

I was disappointed, however, in the way that Bryant kowtowed to the credit-card representatives on the panel: I think they’re clearly a big part of the problem, but Bryant said that he loves credit cards, on the grounds that they represent the only credit line that most poor families have.

My feeling, by contrast, is that credit cards are a really bad way of structuring an unsecured personal loan from a bank to an individual. Banks have made a concerted effort to make personal loans very difficult and expensive to obtain, complete with prepayment penalties and the like, precisely because they’d much rather their borrowers run a balance on their credit cards. And so I had no sympathy at all for David Simon, of Citicards, when he started moaning about how banks were taking enormous credit losses and how “credit card companies are the people that we love to hate”. Well, yes: because they’re basically evil, with what Elizabeth Warren calls their “tricks and traps”. But no one pushed them on this panel.

While the Obama administration continues to push on credit card regulations, and that’s a very good thing, I’d be much more interested in a parallel push to bring back the old-fashioned personal loan: something which is designed to be paid down over time, and which carries a transparent interest rate. Disappointingly, no one on the panel even mentioned the phrase “credit unions”, despite the fact that credit unions in general, and community development credit unions in particular, are a great way to educate the public on financial matters and to extend good loans rather than bad ones.

Instead, the conversation remained firmly at about 40,000 feet most of the time, with lots of talk about things like the parallels between physical and financial health: in both cases Americans have consistently failed to take responsibility for their own well-being, with disastrous consequences.

The most sanity was injected by Sean Cleary, who did push back a bit against the card issuers, saying that an economy with 8.5 credit cards per person is “a completely dysfunctional institutional context”. He also noted a powerful truism:

If you do not have the quantum of life skills needed to succeed in today’s market-based economy, then you will fail.

There was, unfortunately, very little discussion of how exactly to give Americans those skills. There was a reference to a recent paper by Annamaria Lusardi and Peter Tufano, which sought to measure financial literacy, and found that only 7% of people could answer this question correctly:

You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options: a) Pay 12 monthly installments of $100 each; b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?

(i) Option (a);
(ii) Option (b);
(iii) They are the same;
(iv) Do not know;
(v) Prefer not to answer.

Lusardi and Tufano are clear that (ii) is the right answer: a 20% interest rate is much better than the 35% APR on the installment plan, and people who don’t answer (ii) are ignorant, they say, of the time value of money.
But of course there are good reasons to want to pay an affordable repayment every month rather than simply putting off for a year — and exacerbating by $200 — the question of how on earth you’re going to pay for this appliance. If we want financial-literacy classes to be really helpful, I think they should concentrate not on teaching people the “right” answer to a time-value-of-money question, but rather just make people understand that there are fundamental sustainability problems whenever you’re spending more than you’re earning.

Banks are really bad at communicating to their customers that personal loans, including credit cards, should only be used when you are pretty sure that you have a way of paying that loan back in the future. That is real, useful financial literacy, and it requires very little in the way of boring mathematical concepts.

I’m happy however that no one said anything about financial-literacy education involving learning about investments. That’s a fraught area indeed, and it’s far from clear that teaching people about the stock market is ever a good idea. If you want to get rich, there’s really only one way to do it: spend less than you earn. Borrowing money, for most people, is a very bad way of getting wealthier, and investing money, for most people, doesn’t work particularly well either. Don’t count primarily on investment returns: instead, just try to put money away, steadily, month in and month out, until you retire with a decent nest egg.

But pay off those credit cards first.

Update: I’d like to respond to James Shearer, in the comments, who writes this:

Either way you pay $1200. So the second option is clearly better as long as interest rates are greater than 0.

Which is the “right” answer, assuming that a rational person would simply take the $100 a month they’d otherwise spend on the installment plan, and put it in an interest-bearing account: at the end of the year, they can repay the full $1200 in a lump sum, and keep the interest.

But in the real world, people don’t do that. An installment plan is a commitment device, much like a mortgage, and there’s serious value to such a device. Under option (a) you end the year owing nothing; under option (b) you end the year owing $1,200 — and there’s a very good chance that you’ll have no more money then than you do now.


Suna: I too make it 41.3%. But you’ve hit upon a usage difference between the US and the UK.

In the UK, the term “APR” is defined by the Consumer Credit Act 1974 to mean (roughly speaking) the true mathematical (compounded) annual interest rate, rounded to one decimal place.

In the US, “APR” is defined by the Truth in Lending Act 1968 to mean (again, roughly speaking) the periodic interest rate multiplied by the number of periods in a year.

The purpose of each law is to make interest rates easily comparable between financial products, and I suppose this works within each jurisdiction (but in the US it only helps you compare products with the same number of compounding periods in a year). But it makes for a lot of confusion in transatlantic discussions.

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Great Recession datapoint of the day

Felix Salmon
Apr 29, 2009 14:13 UTC

From this morning’s atrociously bad GDP report:

Exports collapsed 30 percent, the biggest decline since 1969, after dropping 23.6 percent in the fourth quarter. The decline in exports knocked off a record 4.06 percentage points from GDP.

By my reckoning, that means exports are now running at half the level they were at six months ago, more or less. (These are absolute drops, right, not annualized rates?) That’s a pretty startling sign of how global this recession is, and how hard it’s going to be to turn things around. Yes, the massive decline in inventories is probably good news. But it’s really hard to see a -6.1% headline figure as anything but a brutal sign that things are continuing to get much worse than almost any mainstream economist (or government stress-tester, for that matter) dared fear.

Update: Turns out that the export declines are annualized: they’re off 11% or so in absolute terms. Which is still bad, but at least it’s not at Japanese levels.


The rates are annualized. The indices on the press release show a drop in exports of just over 11% from 2008Q1. Still, pretty awful.

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Risk management acronym of the day

Felix Salmon
Apr 29, 2009 07:43 UTC

From Mimi Swartz’s 9,700-word monster article on Sir Allen Stanford:

Stanford’s now demoralized compliance department—responsible for making sure the company followed the rules—coined a new term: FUMU, for “fuck up and move up.”

I think this happens at many banks, if not quite as egregiously as it happened at Stanford. It’s the Peter Principle taken one step further: if the people in charge of promotions are themselves utterly incompetent and/or malign, they might well end up promoting fellow-incompetents rather than anybody honest or good at what they do. And it only takes one look at Stanford’s now-arrested chief investment officer to see the natural conclusion of that process.


I believe the expression “fuck up and move up” was first coined in the army during the Vietnam War, and was mention in the book, The Best and the Brightest.

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Tuesday links are likely to be disappointed

Felix Salmon
Apr 28, 2009 23:35 UTC

Frozen-out Stanford investors petition Congress: They were happy parking their money in an offshore bank when it offered too-good-to-be-true yields. But now that bank has imploded, they want onshore financial protections. Good luck with that.

Maiden Lane Transactions: Lots more information on them than we’ve had until now, and all of this could easily have been published at the time they were set up. Alea says that the first one is “strangely made of 80% agency CMOs”.

Ben Graham would be proud: When two economically-identical instruments trade at wildly different prices: the GM example.

Heckle and Chide: Results of a Randomized Road Safety Intervention in Kenya: Putting up signs in minibuses seems to do a good job of reducing traffic accidents.

Blogonomics, or the economics of writing for “free”: Some good analysis from SMI.

Lazard Surprises the Street With a Loss: Even the advisory shops are losing money now.

Bank of America Chief in Battle to Hold His Job: There seems to be a real chance that shareholders might succeed in ousting Ken Lewis. It might not be probable, but the fact that it’s even possible is a sign of the times.


I will make sure to no longer click on reuters. It’s a shame after all these years. You are no longer reliable.

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Dog-cat arbitrage of the day

Felix Salmon
Apr 28, 2009 23:32 UTC

Marion Maneker, on the news that Sotheby’s is auctioning a Giacometti cat:

Le Chat is estimated between $16 and $24 million. One dealer remarked that the Giacometti dogs are $30 million and the cats are generally $10 million but splitting the difference won’t bridge the gap.

In other art-market news, Carol Vogel is noting the rise of private sales as the auction market becomes increasingly dangerous:

Even institutions like the Museum of Modern Art are avoiding auctions. This season it has decided to sell two early classic 1960s paintings by Wayne Thiebaud through Haunch of Venison, a gallery owned by Christie’s. In 2005, when the market was nearing its peak, it sold a variety of works at auction at Christie’s for strong prices.

“There’s an element of uncertainty with an auction that in this climate makes it more prudent to sell privately,” said Ann Temkin, chief curator in the department of painting and sculpture at MoMA. (The Thiebauds were donated to the Modern with the express purpose of selling them to raise cash for future acquisitions.)

There’s some classic art-world fishiness going on here. Why did the owner donate the Thiebauds to MoMA rather than just sell them and donate the proceeds? Firstly, because if you donate the art rather than the proceeds from the sale of the art, you get a certain degree of latitude in determining how much the paintings are worth for tax-writeoff purposes. And secondly, because if it’s MoMA selling the art, rather than a private individual, then the illustrious provenance increases the art’s value — even if the painting has never actually been hung on MoMA’s walls.

I suspect that selling through Haunch of Venison rather than Christie’s proper will decrease the MoMA provenance premium — which only goes to prove how treacherous the auction market is these days. Which raises the question: does MoMA really need to sell the paintings now? Or does it fear that if it doesn’t, then even classic paintings like these will fall even further in price?

Chart of the day: Necessities

Felix Salmon
Apr 28, 2009 23:03 UTC

The Pew Research Center asked 1,003 Americans what they considered to be a necessity, as opposed to a luxury they could live without, and got these results:


My own personal answers, of course, would be very different to these: for one thing, I’ve never owned a car.

I’m quite surprised that the landline phone is still considered more of a necessity than a cellphone — I can’t imagine that’s going to continue to be the case for long. I am interested in the huge drop in the perceived necessity of the microwave, however. Yes, there’s something about microwaves which just feels old-fashioned and unnecessary — but the microwave hasn’t really been replaced by anything. Which I guess just goes to show how much of these determinations is made up of little more than trendiness.

I’m also surprised that 52% of people consider a TV set to be a necessity, while only 23% of people consider cable or satellite TV to be a necessity: subtract the second number from the first, and you get a good indication of the sheer power of network TV. I’m sure that, too, will erode quickly.

The huge drop in the perceived necessity of clothes dryers, home air conditioning, and dishwashers is I think partly a response to the economic crisis, but more a response to the bursting of the housing bubble: people don’t define themselves by their appliances in the way that they did during the housing boom.

What went up in perceived necessity? Nothing, really — nothing more than the margin of error of 3.6 percentage points, anyway. Although it would have been interesting to see the results if intangibles had been included in the survey: friends, family, God, that sort of thing. And I’d also love to have seen them ask about financial services: what’s happened to the perceived necessity of a checking account, or a credit card?



Actually, none of these items are “necessities.” In fact, my great grandparents lived quite happy lives not even being aware of many or most of these things until well into their adulthoods. They all fit into the “nice to have” category. A fairer test would have ranked these “nice to have” things against each other, e.g., given the choice, would you rather be without a car or a telephone?

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