Opinion

Felix Salmon

The Abacus pitchbook

Felix Salmon
Apr 16, 2010 17:32 UTC

Here is the Goldman Sachs pitchbook for the Abacus deal in question today. It spends 30 pages talking in great detail about ACA and its qualifications to manage CDOs; it never mentions Paulson. Here’s my favorite bit:

philosophy.tiff

Not a lot of indication here that the entirety of the Abacus deal was chosen not by ACA’s professionals at all, but rather by Paulson: the extent of ACA’s involvement was limited to picking which deals they wanted from a master list provided by Paulson. In fact, this bit comes close to being an outright lie:

collateral.tiff

Well yes, “selective basis” is one way of putting it. “Selected by John Paulson” is another.

This definitely makes ACA look bad: their name and logo is on every page of this presentation, and they knew full well that the names in the deal were handpicked by someone never mentioned in the pitchbook. Yet they said nothing about this massive lie of omission. Goldman looks worse, of course — and ACA ended up losing hundreds of millions of dollars on the deal. But there are few players who come out well from this sorry saga.

COMMENT

Salmon is still off on this. It’s not helping to make so many errors, as his stuff gets quoted all over and it’s wrong.

“the entirety of the Abacus deal was chosen not by ACA’s professionals at all, but rather by Paulson”

ACA had control over the portfolio. They were allegedly misled on the directionality with which they should have considered Paulson’s input, and that may turn out to be violation, but these were guys that thought housing was going up and were the ones with the responsibility for vetting the deal. ABACUS was being sold to people that thought housing was stable. This quote from the flipbook is a clear disclosure.

“Goldman Sachs will enter into a CDS with the Issuer to buy protection on Reference Portfolio losses related to the Class A through Class D Notes.
- The Collateral Securities and/or Eligible Investments will be available to make payments to Goldman Sachs in the case of writedowns or other Credit Events occurring on the Reference Portfolio, which in each case incur writedowns on the Class A through Class D Notes.
- Goldman Sachs will cover all upfront expenses of the Issuer through an upfront payment under the CDS.
- Goldman Sachs will cover all ongoing expenses of the Issuer through periodic payments under the CDS.”

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Levering up your retirement account

Felix Salmon
Apr 16, 2010 16:22 UTC

Barbara Kiviat has a Q&A with Ian Ayres and Barry Nalebuff, who have taken their paper explaining why young people should buy stock on margin, and have turned it into a book.

I liked — and still like — the fundamental idea here, which Nalebuff sloganizes very well:

Another way of saying it is we believe in stocks for the long run, but most people when they have lots of stocks don’t have the long run and when they have the long run don’t have lots of stocks.

What I’m not at all sure about is the practical mechanics of doing this:

Ayres: That’s a good question. If 2-to-1 is great, why not go to 3-to-1 or 4-to-1? The answer is, the cost of levering becomes too expensive. One of the great pieces of news in this book is that it’s really cheap to borrow money to take levered positions in stock at a 2-to-1 rate. But if you go beyond 3-to-1, it gets prohibitively expensive to borrow money…

Over the past 138 years, the wholesale lending rate for margin loans was just 0.34 percentage points above the T-bill rate. Don’t do it from Vanguard or Fidelity — they don’t have competitive margin rates. But if you shop around places like Interactive Brokers, you can basically borrow very close to the T-bill rate, if you stay at a 2-to-1 basis.

Nalebuff: It’s also possible to do this via long-term options. Ideally, this idea will catch on and there will be funds that do it for you. Today there are a few, like the Ultra Bull fund from ProFunds.

There’s a lot not to like here — starting with the idea of 20-year-olds opening up margin accounts at Interactive Brokers, and continuing with the fact that things like the Ultra Bull fund have a tendency to underperform the stock market even when the stock market is rising. When I first wrote about this idea, I quoted John Waggoner, who pointed out that over the previous five years, the Ultra Bull fund was up 8.8%, while the S&P 500 was up 18.6%.

That was in April 2008, when the Ultra Bull fund was trading at about $60 per share. Since then, it fell to less than $15; it’s still under $40. The fund has high fees; what’s more, it exacerbates the fact that stocks are volatile, and that if you go down 10% and then up 10%, or up 10% and then down 10%, you end up lower than where you started. While I like the idea of adding a bit of leverage to your portfolio when you’re young, I don’t like the idea of doing so via an ETF like this one, and I’m very worried about the fact that Nalebuff is citing it as a possibility.

More generally the amount of discipline that you need in order to successfully prosecute this strategy is absolutely enormous, and human beings tend not to be particularly financially disciplined, especially when they’re young. They’ll abandon the buy-and-hold strategy at exactly the wrong time, selling low and then buying back in at high points; they’ll start using their margin account to try to pick stocks or trade options; they’ll use any profits on expenses rather than keeping them invested and letting them compound.

Meanwhile, of course, the Wall Street institutions letting you borrow on margin are going to be encouraging you to do all those things, while making it as hard as possible for a 20-something to get anything near “the wholesale lending rate for margin loans”.

I haven’t read the book, and so I don’t know how much detail it goes into with respect to actually doing this in reality. But if the best that the authors can come up with is a strategy of buying and rolling over deep-in-the-money LEAP call options, I wouldn’t recommend this to anybody except the extremely financially sophisticated. Who are probably going to make lots of money over their lifetime anyway.

Update: David Merkel adds good points.

COMMENT

I don’t agree with Ayres and Nalebuff:

http://alephblog.com/2010/04/17/dont-buy -stocks-on-margin-unless-you-are-an-expe rt/

Nor does Roger Nusbaum, who is too kind to me:

http://randomroger.blogspot.com/2010/04/ maybe-you-can-buy-and-hold.html

Posted by DavidMerkel | Report as abusive

Goldman’s Abacus lies

Felix Salmon
Apr 16, 2010 15:39 UTC

The SEC suit against Goldman Sachs (full complaint here, and well worth reading) is explosive stuff. Essentially the SEC seems to have nailed down the kind of behavior that ProPublica was looking for in its story on the Magnetar Trade — a hedge fund which was short mortgages, in this case Paulson, was carefully picking nuclear waste to put into synthetic CDOs, unbeknownst to the final investors in those deals.

From the complaint:

GS&Co marketing materials for ABACUS 2007-AC1 – including the term sheet, flip book and offering memorandum for the CDO – all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC (“ACA”), a third-party with experience analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. (“Paulson”), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process.

It seems here that ACA was somewhere between a useful idiot and an outright victim of Goldman’s Fabrice Tourre:

Tourre also misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 (a long position) and, accordingly, that Paulson’s interests in the collateral section process were aligned with ACA’s when in reality Paulson’s interests were sharply conflicting.

Essentially what Goldman was doing here was using the respected ACA brand name (it wouldn’t remain respected for long) in order to attract big investors like Germany’s IKB: they even said in an email that “we expect to leverage ACA’s credibility and franchise to help distribute this Transaction.” But ACA was to a large extent a front for Paulson, as is evidenced in the name of the spreadsheet where it listed the proposed contents of the CDO:

On January 22, 2007, ACA sent an email to Tourre and others at GS&Co with the subject line, “Paulson Portfolio 1-22-10.xls.” The text of the email began, “Attached please find a worksheet with 86 sub-prime mortgage positions that we would recommend taking exposure to synthetically…

On February 5, 2007, Paulson sent an email to ACA, with a copy to Tourre, deleting eight RMBS recommended by ACA, leaving the rest, and stating that Tourre agreed that 92 bonds were a sufficient portfolio.

On February 5, 2007, an internal ACA email asked, “Attached is the revised portfolio that Paulson would like us to commit to – all names are at the Baa2 level. The final portfolio will have between 80 and these 92 names. Are ‘we’ ok to say yes on this portfolio?” The response was, “Looks good to me.”

I think that the SEC has the right defendant here. Paulson and ACA are both culpable, but it’s Goldman which was clearly central to the plan of deceiving investors into believing that the CDO was being managed by people who wanted it to make money, when in fact it was being structured by the biggest short-seller in the entire subprime market.

And although ACA should never have been so passive in terms of accepting the names given to it by Paulson, it did reasonably believe, because it was essentially lied to by Goldman Sachs, that Paulson was in the deal to make money on the long side:

On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% – [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% – [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% – [9]%” first loss equity tranche in this transaction…

On February 12, 2007, ACA’s Commitments Committee approved the firm’s participation in ABACUS as portfolio selection agent. The written approval memorandum described Paulson’s role as follows: “the hedge fund equity investor wanted to invest in the 0- 9% tranche of a static mezzanine ABS CDO backed 100% by subprime residential mortgage securities.”

The really crazy thing about this deal is that ACA not only managed the CDO, but also wrote the credit protection underlying most of it:

On or about May 31, 2007, ACA Capital sold protection or “wrapped” the $909 million super senior tranche of ABACUS 2007-AC1, meaning that it assumed the credit risk associated with that portion of the capital structure…

ACA Capital was unaware of Paulson’s short position in the transaction. It is unlikely that ACA Capital would have written protection on the super senior tranche if it had known that Paulson, which played an influential role in selecting the reference portfolio, had taken a significant short position instead of a long equity stake.

In a sense, then, IKB and the other investors in the deal were right to think that ACA was genuinely managing this structure to make money, and believed that it was sound. After all, if it all went to zero — as it eventually did — ACA stood to lose hundreds of millions of dollars.

But what happened here was that both IKB and ACA Capital placed their trust in ACA Management. And Goldman, armed with hefty CDO management fees and sleazy lies about Paulson’s role in the transaction, turned ACA Management from a bona fide fund manager into a useful idiot who could be relied upon to buy exactly the subprime securities that Paulson wanted to short.

With this suit, the SEC has finally uncovered the real scandal behind the Abacus deals. The NYT tried, back in December, but it didn’t quite get to the nub of the story — although Paulson was mentioned in the NYT story as someone who was generally short the subprime market, there was no indication that he played any role in structuring the deals. Neither was there any mention of ACA.

The scandal here is not that Goldman was short the subprime market at the same time as marketing the Abacus deal. The scandal is that Goldman sold the contents of Abacus as being handpicked by managers at ACA when in fact it was handpicked by Paulson; and that it told ACA that Paulson had a long position in the deal when in fact he was entirely short.

Goldman Sachs has lost more than $10 billion in market capitalization today, in the wake of these revelations. Good. It can go long markets and it can go short markets. But it can’t lie to its clients. That’s well beyond the pale.

Update: The Abacus pitch book can be seen here.

COMMENT

Did IKB believe Paulson was long on the deal? It seems to me IKB would be called to testify at the civil trial to clear up this issue.

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The punitive bank tax

Felix Salmon
Apr 16, 2010 13:46 UTC

Jamie Dimon’s attempt to push back against the Obama administration’s proposed bank fee only goes to prove just how out-of-touch Wall Street really is:

Today, however, Dimon appeared to open another line of assault on the would-be reformers. His beef this time was about proposed levies to recoup the cost of bailing out US banks, the part of the reform agenda that is far less controversial. “Let’s all not call it a bank fee and call it what it is – a punitive bank tax,” said Dimon.

OK, Jamie, let’s do that. You honestly think that would make it less popular? It’s a bank tax, and it’s being enacted so that banks, rather than taxpayers, bear the pain of the TARP bailout. That’s entirely right and proper.

Dimon has spent his whole life on Wall Street, and although he’s respected by Wall Street standards, he doesn’t seem to understand how weak that really is. Any popular opposition to the Democrats on this issue is very much that they’re too friendly to the banks, not that they’re too harsh. And the Republicans have worked this out: while they’re doing the banks’ bidding and opposing the Dodd bill, the language they use while opposing it in public makes it sound as though the Democrats don’t go far enough in terms of making the banks pay for their own mistakes.

Taking the bank fee, then, and renaming it the “punitive bank tax” is, I think, a jolly good idea — if only because it helps to remind people just how culpable Wall Street was in the financial meltdown, and how little it seems to have suffered.

COMMENT

Well, isn’t this a voluntary tax? Don’t take on leverage, don’t pay tax? It sure is a lot lower rate than the tax I pay on cigarettes, alcohol or gambling–all voluntary taxes. At least my vices add a boost to the economy, and no bailouts are available.

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Counterparties

Felix Salmon
Apr 16, 2010 04:34 UTC

Argentina Offers 66.3% Haircut in $20 Bln Bond Swap — iMarketNews

Clark Hoyt, the NYT public editor, adjudicates Krugman vs Sorkin, comes down in favor of Krugman — NYT

Israel vs the iPad: Imports are banned and customs agents are confiscating devices — AtlanticWire

Mr. Murdoch and family find faith, fame and Nicole Kidman by the River Jordan — NYT

Central clearing of derivatives is a good idea — but only if the clearer is robust. There are questions over IDCH — Risk

“Barneys has been able to get away with it for the past quarter-century only because it hasn’t antagonized any powerful hippie conglomerates” — Racked

If the WSJ is trying to go more mainstream, why did it replace John and Dottie with the self-parody of Jay McInerney? — WSJ

The Brooklyn Museum’s Andy Warhol pinata — BM

Boone and Johnson, having brought down Greece, move on to Portugal — Baseline Scenario

COMMENT

The spat between the two NYT columnists makes me respect Sorkin much less. Even as a casual reader of Krugman’s column and blog, I came away under the impression he was in favor of nationalizing banks in deep trouble, vs. pumping money into them, both because of moral hazard and turning them into zombie banks (as happened in Japan).

Advocating nationalizing the entire US banking system would be a VERY BIG deal and I would not have missed that if Krugman did advocate it. Sorkin seems to be arguing that he didn’t mis-categorize Krugman’s position, it’s all just a matter of semantics.

Well, I beg to differ. Sorkin is paid to read the news and analyze and comment on them; I’m not. And if I know the difference between what he said Krugman said and what Krugman actually said, he definitely should know it. Just come out and apologize already. We all make mistakes, the point is we learn from them and not repeat it. To deny our mistakes is much much worse than the actual mistakes, in most cases.

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When right-to-rent meets principal reduction

Felix Salmon
Apr 15, 2010 20:53 UTC

What happens when you cross right-to-rent with mortgage principal reductions, and turn the whole thing into an entirely voluntary private-sector program with no government involvement whatsoever? It might look a little bit like American Homeowner Preservation, a for-profit company which has a very interesting idea for keeping people in their homes.

The details can be found here: the core of the scheme is where AHP persuades a lender to accept a short sale on a home. That’s the principal-reduction bit; the right-to-rent bit then kicks in when the buyer of the home — an AHP client, along with the seller — agrees to rent back the home to the former owner at a low, affordable rate which can’t be more than one-third of the tenant’s income. Rent increases by 5% annually for five years; at any point, the tenant has the option to buy back the home at a predetermined price which rises year by year; tenants get financial counseling to enable them to do that.

The buyer can sell the home at any point in the first five years subject to the existing lease and option; after that, it’s put on the market and any profits over and above the option price get split equally between the buyer and the tenant.

If everything goes according to plan, the buyer makes healthy returns: here’s one financial projections sheet which foresees returns in the low double digits. And the homeowner ends up buying back their own home for much less than they originally bought it for. Meanwhile, AHP makes relatively modest fees of a few thousand dollars along the way.

I don’t know much about American Homeowner Preservation, and their website could use a bit of work. But in principle, I think there’s a very good idea here. Any bank dealing with AHP is going to want to make very sure they’re getting a genuine market rate for the house in question, but so long as that’s the case, and the bank is open to short sales in principle, this looks like a win-win for all concerned. The owner gets to stay in their house, the bank gets to avoid the expense of foreclosure proceedings, and the investor gets decent returns. Clever!

COMMENT

Actually, this is this the real deal folks! I too am one of the investers who purchased a home thru AHP. The previous homeowner was about to lose their home to foreclosure – literally the same week that we closed. So, in affect the previous homeowner was able to stay in their home (now as a renter) saving everyone alot of grief. The grief being legal fees for the banks pursuing foreclosure/ auctions, and the previous homeowner of completely losing everything he and his family had put into this home for the last 20 years.
Also, as the first ignorant person commented, the banks do Not have their hands in the cookie jar. He/she quoted, “The banking executives who now have the cash to start this company because of the bank bail outs and the morally deficient friend living it up on the taxpayer dollar.” I know that AHP fought with the banks over a year to get the short-sale approved in my case. If the banks had an incestous relationship with AHP, it would have happened alot quicker than that. I’ve had numerous talks with AHP, and believe me it takes alot of time and effort to convince the Big dopey banks that it will be much better to execute a short-sale than pursue the alternative. But wake up!!! Short-sales are happening whether or Not AHP exists. At least with AHP, they are looking for the best alternative to this Housing crisis and helping to minimize the pain for everyone. It’s good karma here folks. Instead of seeking “an eye for an eye and a tooth for a tooth” metality, we need to find a solution to this madness. And I believe AHP has done just that.

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Shleifer vs Milken on financial innovation

Felix Salmon
Apr 15, 2010 19:05 UTC

Yesterday I went to a seminar at NYU where I heard Andrei Shleifer defend his paper on how financial innovation causes crises. At the same time, Mike Milken published an op-ed saying that financial innovation is a wonderful thing, and that what we really need to worry about is too much leverage and too little assiduous underwriting. “Over the long run,” he writes, “the best way to maximize profitability is not to increase leverage, but rather to analyze credit properly”.

This is true, but Shleifer’s point is that it becomes much harder to analyze credit properly if you’re constantly trying to analyze new products without any real-world past history. In the world of credit, innovation generally consists of taking risky stuff, waving some kind of diversification and/or overcollateralization magic wand, and ending up with something which is (a) meant to be safer, and (b) much more difficult to analyze on a fundamental basis: you end up having to use models instead. And models have a tendency to break.

The Milken Institute’s Glenn Yago, in the comments to my initial post on the Shleifer paper, lauds CLOs as wonderful innovations, in contrast to CDOs, on the grounds that they outperformed CDOs during the crisis. But that’s ex post — and the fact is that during the crisis the prices of CLOs dropped sharply, if they were traded at all, entirely in line with what Shleifer’s paper would predict. The point is, says Shleifer, that when people bought triple-A-rated CLOs, they wanted something completely riskless. As a result, the mere realization that there’s a possibility that they won’t get paid out in full is sufficient to see them collapse in price, given the way in which such instruments tend to have been oversupplied by the market.

“The amount of financial innovation is incredibly sensitive to how people think about risk,” said Shleifer. “That’s the point of the model.” In boom times, people think locally, don’t think about tail risk, and pile in to innovative financial products, which banks are happy to pump out in essentially unlimited quantities. In crunch times, people get much more cautious, don’t trust models any more, and flee to the safety of traditionally risk-free products like Treasuries.

This is all true pretty much regardless of the actual product in question. In this rebound, CLOs have obviously outperformed CDOs, since there’s real value in CLOs, while a lot of CDOs are simply going to zero and staying there.

The point is that when Milken says that “credit research should go far deeper than ratings” while at the same time lauding the innovation of collateralized loan and bond obligations, he’s trying to have his cake and eat it. You can do deep credit research on a plain-vanilla unsecured bond or loan. But when you start adding bells and whistles to it, and burying it within much larger and more complex securitization and passthrough structures, deep credit research becomes much, much harder — to the point at which, with CDO-squareds, it’s essentially impossible. At that point, you’re forced to rely on models and Monte Carlo simulations and the like.

In this crisis, model risk went, pretty much overnight, from something which no one spent much time worrying about to something which everybody was terrified of. And so good CLOs sold off alongside bad CDOs. And that exacerbated the crisis. That’s endemic to financial innovation: it’s a real bug in the system. And no one at Milken seems to be willing to admit it.

COMMENT

Felix, loans have strong covenants and bonds don’t. That’s the main difference.

Posted by DavidMerkel | Report as abusive

Pirrong on the CME and Lehman

Felix Salmon
Apr 15, 2010 16:09 UTC

Craig Pirrong has a thoughtful response to the unredacted Valukas report on the CME and Lehman, and in particular to my take on it. He explains clearly the reasons why Lehman’s CME positions were sold for $1.2 billion less than their market value:

Prices were extraordinarily volatile, and they could be expected to get only more volatile in the aftermath of a Lehman bankruptcy. Moreover, liquidity was drying up, major financial institutions were suffering serious liquidity strains, and could not count on tapping the capital necessary to carry big risk positions. Given the conditions in the market, it was possible that it would take some time to unwind positions assumed in the auction, and that the winning bidders would have faced considerable risk of loss during that unwind process. In these circumstances, it was inevitable that firms would assume these positions only at discounted values.

So given all that, why did the CME auction off the positions? Because if it hadn’t, then it was theoretically possible that Lehman’s margin positions might not have sufficed to cover the losses associated with the positions. And in that case the CME would have become a Lehman creditor, and it didn’t want to risk that. Pirrong writes:

Clearing does not make risk disappear. The experience of CME with the Lehman situation shows that clearly. Forcing risks that are harder to manage into a clearinghouse does not necessarily improve the safety of the financial system. It could do the exact opposite, by threatening the safety of clearinghouses that could handle the risks they currently manage, but not the additional, more problematic risks forced upon them.

It’s undoubtedly true that moving risks onto a clearinghouse increases the amount of risk which is in the clearinghouse. That’s a feature, not a bug, since the clearinghouse is focused, daily, on managing its tail risk. Because clearinghouses don’t trade daily, and don’t have a daily P&L, the tail risk is the one big risk they have to manage.

And yet when finally faced with such a risk, in the wake of Lehman’s failure, the CME’s reaction was to panic and spend any and all of Lehman’s collateral just to get the risk off its own books and somewhere — anywhere — else.

The point here is that the CME was incredibly cavalier with other people’s money, the minute those other people went bankrupt. If it had held onto the positions and they ended up being wound up or expiring at a profit, then the collateral would not have gone to the CME, it would have gone back to the Lehman estate. So the CME had no incentive to do that. Instead, it seized the collateral and threw it at Goldman Sachs, Barclays, and DRW Trading. It wasn’t the CME’s money, and it surely made those major CME clients very happy, so everybody wins. Except Lehman, and who cares about them — they’re bankrupt.

Here’s Pirrong:

The whole reason that many–including Salmon–advocate a move to clearing is to protect other financial entities from the knock-on effects of a default by a particular entity. That’s exactly what CME was trying to do: to protect the other clearing members from the knock-on effects of a default.

Actually, the CME was trying to protect itself from any possible negative effects of a Lehman default, despite the fact that it possessed of billions of dollars of Lehman’s money: the mere existence of the CME helps to protect other clearing members from the counterparty risks associated with something like a Lehman default. That’s why central counterparty clearing is a good thing. The CME, however, was happy to pay out $1.2 billion of Lehman’s money to insulate itself from tail risk. Which is a very large sum of money. As Valukas says, there’s a colorable claim there from Lehman’s creditors.

COMMENT

You still don’t quite get this, Felix, although you’re getting closer.

“Actually, the CME was trying to protect itself from any possible negative effects of a Lehman default, despite the fact that it possessed of billions of dollars of Lehman’s money: the mere existence of the CME helps to protect other clearing members from the counterparty risks associated with something like a Lehman default.”

Well, yes and no. Assume CME holds onto the positions in an attempt to secure a better deal for Lehman creditors, and assume the eventual losses exceed margin – who covers the addditional loss? The dealers, through the funds they provide mutually to CME’s clearing fund. And who would be asked to stump up additional capital to keep CME afloat if this was burned through? Again the dealers. Pirrong’s right here (and most other places).

A second point is that Lehman went into the clearing house with its eyes open – it knew that something like this would happen if it ever got into difficulties. Of course, that risk was no doubt mispriced, along with everything else, in the build-up to the crisis.

Having said that, there seems no doubt CME’s processes could have been better designed. Compare the arrangements of the London Clearing House in the UK, which had an established and tested auction facility.

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Worrying about a Greek bank run

Felix Salmon
Apr 15, 2010 14:44 UTC

I haven’t previously heard of Cumberland Advisors, a money manager in Sarasota, Florida. But they’ve been writing some great stuff on the subject of Greek bank runs.

First of all David Kotok set the stage:

Banks in Greece are experiencing runs in the billions of euros. Remember, depositors can remove their money and redeposit in another country in another bank and still do business in the euro. There are sixteen countries in the euro zone. The banking options for euro zone citizens are varied and abundant.

The bank deposit scheme in the euro zone leaves deposit guarantees in the hands of the national governments. In this case Greece is the guarantor. And since the country is in trouble because if its fiscal deficit issues, its banking system is also in trouble. That is because the strength of the national banks deposit guarantees are dependent on the strength of the government’s finances.

Could Greece go the way of Argentina or Iceland, he asked, where deposit insurance turned out to be worth very little? Kotok was ulimately sanguine.

But then Bob Eisenbels picked up the story in a fantastic entry yesterday, comparing Greece’s deposit insurance today to state deposit insurance in the US. The history here is not encouraging:

The US has had a long history, going back into the early 19th century, with decentralized state-sponsored deposit insurance systems that were not backed by the federal government. This includes the New York safety fund system; funds in Vermont and Michigan that were established in the 1800s; and funds in Oklahoma, Kansas, Nebraska, Texas, Mississippi, South and North Dakota, Ohio, Maryland, and Rhode Island that were put in place in the early 1900s. All of these programs failed within a few years. Most recently this happened to the Maryland and Ohio deposit insurance systems in 1985 and Rhode Island in 1991.

Eisenbels points out that in 1985 and even today, Ohio’s GDP is larger than that of Greece.

Bank runs are, by their nature, unpredictable things. WaMu suffered a big run, for instance, despite being FDIC insured, while uninsured customers at Citibank left hundreds of billions of dollars on deposit there, even as Citi teetered on the brink of insolvency. (Most of Citi’s depositors are uninsured, since most of its deposits are overseas.)

But there’s clearly a systemic risk to the Greek economy from bank runs, and it’s unclear how the EU is going to deal with this problem. Maybe there will start to be noises about an implicit EU backstop of Greece’s deposit insurance scheme — but I’m not sure that vague noises would suffice. I suspect that the main obstacle to a run is that Greece neighbors no eurozone country, and so it’s not exactly trivial for a Greek depositor to move her money to a non-Greek bank. Let’s hope that’s enough, for the time being.

COMMENT

Under EU rules, deposits at branches are covered by the deposit guarantee scheme of the country of the bank HQ. In the case of the Icesave branches in Amsterdam and London, the deposits should have been guaranteed by Iceland’s guarantee scheme. (the problem in that case is that the Icelanders have not paid anything to the depositors).
Subsidiaries, however, are covered by the host state system. So Greek depositors should check whether they deposit with a branch or a local subsidiary.

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