Felix Salmon

Chart of the day, bank-lending edition

Felix Salmon
Sep 17, 2013 16:47 UTC

Well done to Matt Levine for finding — and explaining very clearly — the BIS’s special feature, by Ben Cohen, on the way in which the world’s banks have adjusted to higher capital requirements. Basically, the BIS, which sets the Basel capital requirements for the world’s banks, wanted to know how banks reacted when those capital requirements were raised.

The first thing that happened is that the banks did, in fact, become significantly better capitalized — and that is especially true of what the BIS calls “large, internationally active banks”. Since those are the banks we’re mainly worried about, this is definitely good news. Those banks were well below the Basel III minimum at the beginning of 2010, but they reached it by mid-2011, and they comfortably exceeded it by mid-2012, well ahead of the Basel III schedule.

The banks achieved this feat in the most painless way possible: they simply retained their earnings, rather than paying them out in dividends. And those earnings weren’t easy to come by, either. The banks in general shed what Levine calls “income that lots of people find naughty, prop trading and so forth”, which reduced their overall profitability. The banks instead had to make money the old-fashioned way, by lending it out at a higher rate than their cost of funds. Net interest income, across all global banks, rose substantially from the pre-crisis period to the post-crisis period: it was 1.34% of assets in 2005-7, and 1.62% of assets in 2010-12.

Here’s where the slightly disappointing part of the story comes in, though: despite the fact that their loans were more profitable than ever, the banks didn’t actually lend more, overall. The BIS report has some rather confusing charts on this, so here’s a FRED chart I put together, showing total US bank credit, in constant 2008 dollars, over the past 15 years:

The story here is clear. Total credit was rising at a very steady real pace for the decade running up to the crisis — but then it stopped growing when the crisis hit, and it has never really recovered.

Levine, and the BIS, put a positive spin on this, saying that the banks “are not cutting back on lending”. Which is true — but they’re not exactly fueling the recovery, either. Indeed, this chart is worse than what we would have seen if the banks had just rolled over all their existing loans and made no new loans at all.

That said, I’m not sure that this chart is really bad news. If you stipulate that there was too much lending in the economy in 2008, and that we needed to enter a period of slow deleveraging, this is actually exactly what the doctor ordered.

One way of reading the BIS report is to think of a set of trade-offs between three constituencies: banks, borrowers, and regulators. When the regulators got tough and implemented Basel III, the main losers were the banks, which lost a lot of permanent profitability. But borrowers were also hit: they’re paying more for loans, and they’re not being given as many loans as they were in the past. The big winner, meanwhile, was society as a whole, which significantly reduced the amount of systemic risk in the banking system.

The BIS is not entirely unsympathetic to the banks. In fact, in a quite astonishing passage which Levine picks up on in a footnote, they suggest that maybe the banks could form an informal cartel, passively agreeing not to compete with each other on lending rates:

The bank could seek to reduce the share of its profit it pays out in dividends. Alternatively, it may try to boost profits themselves. The most direct way to do so would be by increasing the spread between the interest rates it charges for loans and those it pays on its funding. While competitive pressures may limit how much an individual bank can widen these spreads, lending spreads could rise across the system if all banks followed a similar strategy and alternative funding channels (such as capital markets) did not offer more attractive rates.

Remember that from a regulatory perspective, a highly profitable bank is a significantly better bet than one with narrower profit margins. Regulators want banks to make good money: it makes their own job a great deal easier. And if that comes from charging borrowers higher rates, so be it.

What’s more, banks actually have the ability to do this relatively easily. Borrowers who don’t have direct access to the capital markets — which is the overwhelming majority of us — are not, in reality, particularly price-sensitive when it comes to lending rates. Payday lenders learned this lesson years ago: borrowers value convenience much more than they do lower interest rates. And as a result, banks actually have quite a lot of leeway to raise lending rates if they want to, at least when it comes to individuals and small businesses.

And in reality, a large part of the stagnation in bank lending has to be a consequence of the fact that the economy as a whole is evincing little demand for credit. Individuals are more interested in paying down their debts than they are in borrowing more; businesses, too, have learned the hard way that debt has a tendency to bite, hard, at the worst possible moment. If higher lending spreads help to discourage borrowing, at the margin — and maybe conversely encourage businesses to take some kind of equity funding, instead — then possibly they will result in a more resilient economy overall.

For the time being, as well, higher bank spreads are no big deal, just because the banks have such an incredibly low cost of funds: the actual nominal interest rates being paid by borrowers are still extremely low. My own bank recently offered me, out of the blue, a free, unsecured credit line at 6.3%: that’s well above their cost of funds, but it’s still a very low interest rate, in the grand scheme of things, should I find myself in a position where I need to take advantage of it.

So I’m with Levine on this one: so far at least, Basel III seems to be working in an almost optimal manner. We’re used to a world where the only way you can achieve growth is through leverage — and we learned, with extreme pain, that leverage is a very dangerous thing. This recovery, by contrast, is not being driven by leverage. And that is surely a good thing.


What’s the downside? I don’t know – what was the downside of the dot.com easy money bubble or the subprime/CDS easy money bubble? You are an inspiring figure Mr. Salmon – don’t know a damn thing about something as basic as this, yet hired on by a major news organization to write a financial blog. Keep up the good work, you may be plucky and ignorant enough to be a Federal Reserve Chairman someday.

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Judging Treasury

Felix Salmon
Sep 16, 2013 15:56 UTC

There’s a fascinating heavyweight fight going on when it comes to writing what you might consider the official narrative of the financial crisis. The White House released its own 49-page report this morning, talking in glowing terms of the successes that the Obama Administration has made on the financial-reform front. Meanwhile, this week’s issue of Time magazine takes the opposite tack in a tough cover story by Rana Foroohar, headlined “How Wall Street Won”.

The interesting thing about this fight is that it has actually been engaged: Treasury responded to Foroohar on its website, and she of course replied to them. (If the first link to her cover story steers you into a paywall, then try going from her blog post: that might work.)

It’s also worth noting Foroohar’s “to be sure” sentence, in her introduction: “The truth is,” she writes, “Washington did a great job saving the banking system in ’08 and ’09 with swift bailouts that averted even worse damage to the economy.” She’s right about that — but neither side of the debate dwells for long on that fact, partly because most of the emergency actions which saved the banking system were put in place by the George W Bush administration, rather than the current lot.

If you think of the economy as a ship, then what the Obama administration inherited was a crippled vessel, still afloat, but badly damaged from a serious fire in the boiler room. It had fallen to the Bush administration to actually put out the fire, which they did. And so the Obama administration set to work trying to fix the ship, with things like the original stimulus package. And they also had to fix up the damaged boiler room, and ensure that it would never again explode in such a devastating manner. That was the job of Dodd-Frank, as well as Basel III.

Foroohar’s point is pretty simple. The US economy is far from ship-shape right now — just look at the unemployment rate, or the employment-to-population ratio, or the median wage, or any other measure of how the broad mass of Americans is faring. The 2009 stimulus might have done a bit of good at the margin, but here we are, five years after the crisis, and the Federal Reserve still feels the need to pump $85 billion a month into the economy in its latest round of QE, on the grounds that interest rates are at zero and can’t be lowered any further. The economy, in other words, finds it hard to stay afloat without artificial aid.

And then, when you go down into the boiler room, it has been patched up here and there, and people are still working on some of the more damaged areas — but if you look at the whole thing, it’s not exactly explosion-proof. Sure, it’s safer than it was in 2007, but that’s not saying very much. And when people like Gary Gensler try to come in and add some crucial regulators to highly dangerous parts of the system, they get stymied — by none other than Treasury itself!

Treasury’s take, by contrast, is more granular. Look at TARP — it made money! Look at the stress tests — they worked! Look at the first derivatives on measures like house prices, credit flows, and total household wealth — they’re positive!

Neither take tells the whole truth, although the Obama administration is probably the more disingenuous of the two: “as a matter of law,” writes Treasury’s Anthony Coley, “Dodd-Frank ended the notion that any firm is ‘too big to fail.’” Er, no, it didn’t. Lots of us still have the notion that there are dozens of firms which are too big to fail — and other entities, too, like the state of California. It might be less likely, now, that any given firm will fail. What’s more, if and when a big firm does fail, there’s now a semblance of a procedure to follow, which — if everything goes according to plan — might even involve zero federal dollars. But still, too big to fail is too big to fail, and ultimately, if push comes to shove, the implicit government backstop is still there.

The thing is, the TBTF problem is endemic to modern finance — there was no realistic way that the Obama administration or any other government could ever stop it from being the case. In theory, we could have let the entire boiler room melt down, to the point at which it could no longer inflict any more damage. That’s what Michael Lewis thinks we should have done: “I don’t feel, oh, how sad that Lehman went down,” he says. “I feel, how sad that Goldman Sachs and Morgan Stanley didn’t follow. I would’ve liked to have seen the crisis play itself out more.” But if that had happened, the whole ship would have sunk — and would have taken the entire global economy down with it. Yes, there’s moral hazard in bailing out banks. But the time to deal with moral hazard is before the crisis hits. Once the boiler room is ablaze, the first job of the stewards of the ship is, always, to put out the fire. Even if — especially if — that means protecting parts of the system which are inherently dangerous.

Ultimately, I think that both the White House and Foroohar are far too invested in a narrative where the government is in control, and can effectively determine the state of not only the US financial system but also the entire US economy as a whole. When in fact, of course, it can’t even nominate its preferred candidate to become the chairman of the Federal Reserve. The Obama administration could have done better, both in terms of bank regulation and in terms of broader macro policy. But it was operating within real constraints, both nationally and internationally. And the prospect of fireproofing the engine room so that no crisis would ever happen again — well, that was always impossible, for any government, in any country bigger than, say, Bhutan.

Overall, if Treasury is giving itself an A for its post-crisis actions, and Foroohar is handing out a C, then I’d duck the question and point to the bigger truth — that the quality of Treasury’s actions is not nearly as consequential as most people think. We live in a path-dependent liberal democracy, and the older our democracy gets, the more entrenched it becomes, and the harder it is to change anything truly fundamental. Treasury’s tinkering was, at the margin, a positive force, and I’m glad they did what they did, even as I wish they had done more. But I don’t kid myself that if they had done more, it would have made all that much of a difference. Or, for that matter, that if they had done less, things would have been noticeably worse than they are right now.


You forgot something, Felix. The Obama Administration inherited a crippled ship with a damaged boiler, AND FIVE MILLION PASSENGERS THROWN OVERBOARD into unemployment, plus another 4 million hanging onto the side of the ship about to fall in. Oh, and half the crew was planning a mutiny and refused to help the captain right the sh.

A bit hard to replace the boiler when you are trying to fish the survivors out of the water. And when half the crew is planning a mutiny and refusing to help the captain right the ship.

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Summers over

Felix Salmon
Sep 15, 2013 20:58 UTC

David Wessel has the scoop: Larry Summers has bowed to reality and is withdrawing from consideration as Fed chair. His last-minute attempt to distance himself from Citigroup was far too little, far too late: with Democratic opposition in the Senate only getting harder, it was at this point more likely than not that any Summers nomination would actually fail to get through Congress.

Michael Hirsh’s anti-Summers National Journal cover story landed on the desks of everybody who matters in Washington at the end of the week, and it had its intended effect: no matter how much the White House wanted Summers to get the job, those pesky Constitutional checks and balances would conspire to ensure that it would never be his.

This is extremely good news, of course. Summers was the wrong man for the job, and his withdrawal leaves the door wide open for the best-qualified candidate, Janet Yellen, to step into the chairmanship. Summers simply shouldn’t be a leader of any major institution: he’s too cocksure, too abrasive. He failed at Harvard; since then, his metier has been that of consigliere: quietly (or not so quietly) whispering in the ear of real leaders like David Shaw or Barack Obama. He’s good at that. But Summers has tasted real power, first at Treasury and then at Harvard, and is young enough, and ambitious enough, to want to relive the experience.

It’s not going to happen — not at any major public institution, in any case. Summers didn’t become Treasury secretary, when Obama first took office; he didn’t become the head of the World Bank; and he has now failed twice to become Fed chair. That’s it: four strikes, and he’s done. He is now free to make many millions of dollars in the private sector — or, rather, to continue to make many millions of dollars in the private sector, since he’s a prime example of a man who revolves straight into highly-paid consultancies the minute he leaves government.

The presumptive-nominee status of Yellen will leave a bad taste in many White House sources’ mouths — they’ve been quietly briefing against her for months, and the unedifying spectacle of seeing the Fed chairmanship turn into a horse race has done her no particular favors. Obama should know, however, that if he nominates any man whatsoever for the job, the howls from women will be heard very loudly indeed.

The real lesson of the past few months, however, is that the Fed chairmanship should never become a political football. If Obama wanted to nominate Summers, he should have just done so, rather than raising a trial balloon in July and then letting it slowly deflate. Both Alan Greenspan and Ben Bernanke were nominated by a Republican and then re-nominated by a Democrat: that above-politics status is exactly as it should be. I hope that Washington will learn from this debacle, and that if the Republican candidate wins the next presidential election, he or she will feel free to re-nominate Janet Yellen. That would be the sign we all need that the Fed chair is a technocratic position, not a political one.


Summers was wrong fro the job agreed. But Yellen? Gender aside the record of the fed through the crisis has been one of abject failure.

The choice between summers and an insider is startlingly poor.

Surely there were better choices?

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Whither bond returns?

Felix Salmon
Sep 13, 2013 16:22 UTC

Mohamed El-Erian has a big-picture look at the bond market today, which leads off with a look back to where we were at the end of April. Back then, a diversified bond portfolio, as measured by the Barclays Aggregate index for the US, showed solid returns, between 3.6% and 6.0%, for every period between 1 year and 20 years. I’ve annotated El-Erian’s chart to show what has happened to those returns in the past 4 months: the numbers on the right are updated to today. As you can see, the 1-year return has fallen from 3.6% to -2.5% — a drop of more than 600 basis points — and all the other figures have fallen as well.

El-Erian explains that the consistent and gratifying numbers posted by fixed-income portfolios were the result of a “virtuous circle”, where four different drivers all fed each other and helped push returns upwards:

  • A secular fall in interest rates;
  • A consistently negative correlation between fixed-income returns and equity returns, over a six-month time horizon;
  • Monster flows into the asset class;
  • Direct support from central banks.

Now, however, those four drivers are coming to an end. Interest rates are at zero; they can’t fall any lower. Over the long term, they have nowhere to go but up. Total assets in fixed-income profiles rose from $4.7 trillion in 1998 to $12.1 trillion at the beginning of 2013 — but now flows have turned negative, and investors are pulling their money out of bonds. And while the Fed is still spending some $85 billion a month buying bonds in the secondary market, that isn’t going to last forever: the taper is coming, sooner or later.

That leaves only the negative correlation between bonds and stocks, which is more of a short-term thing than a long-term thing (after all, both bonds and stocks should post positive returns over the long run), and which is ultimately just a way of greasing the wheels of the virtuous cycle; it can’t do much to boost returns in and of itself.

Which raises the question: we’ve already seen a substantial reduction in total fixed-income returns. If the virtuous cycle is now becoming a vicious cycle, should we expect the numbers to continue to deteriorate for years and even possibly decades to come? Is it possible that in the wake of many years of consecutive positive bond-market returns, we might start seeing a bunch of back-to-back negative returns going forwards?

Simon Lack, for one, would hold that view. El-Erian, who is the world’s largest bond investor, naturally takes the opposite view:

History will regard the ongoing phase of dislocations in the bond market as a transitional period of adjustment triggered by changing expectations about policy, the economy and asset preferences – all of which have been significantly turbocharged by a set of temporary and ultimately reversible technical factors. By contrast, history is unlikely to record a change in the important role that fixed income plays over time in prudent asset allocations and diversified investment portfolios – in generating returns, reducing volatility and lowering the risk of severe capital loss.

The problem is that El-Erian doesn’t really nail his case. He’s good on the short-term factors, and he’s very good on the pockets of the fixed-income universe which are looking particularly attractive right now. If your fixed-income money is invested with Pimco, you can be sure that El-Erian and his thousands of employees are working very hard to maximize the returns that it’s going to generate. But in aggregate, is the bond market still a great place to park long-term funds?

We can be pretty sure that sooner or later, QE is going to end, and then at some point the Fed is going to start raising nominal interest rates. Which means that the bond market as a whole will be, in El-Erian’s terms, sailing into headwinds rather than having the wind behind its back. And although China isn’t going to stop saving any time soon, one does have to wonder whether the fixed-income asset class, which was artificially boosted by risk aversion following the financial crisis, might not see some mean reversion in terms of the total amount of money invested.

For me, the most interesting investing question right now is this one: assuming we’re about to see a long-term secular period of rising interest rates, what can we expect in terms of overall fixed-income returns? There’s no particular reason why bonds shouldn’t continue to see positive and relatively stable returns even if rates are rising. After all, rising rates coincide with greater economic activity, which generally compensates funders for providing capital. And the shape of the yield curve can do a pretty good job of charging borrowers for anticipated future rate hikes.

But the fact is that no one really knows the answer to the question. If you look at El-Erian’s post, it’s good on what’s going to happen in the short term, but it says very little about where returns are going to come from over the long term. Which is probably fair enough. But before I tied up a lot of money with Pimco, or with any other fixed-income investor, I would like to see a thought-through explanation of how and why I shouldn’t be too worried about entering what is sure to be a long-term period of rising interest rates.


I think there are two issues at play in the fixed-income markets that make the coming years particularly interesting for asset allocators. The first is a rising rate market, the effects of which I discussed in my blog (http://blog.thinknewfound.com/a-simple- formula-to-understand-the-effects-of-ris ing-rates-on-constant-maturity-fixed-inc ome-etfs/). The second is the potential for positive correlations between equities and fixed income, which I discussed in another blog post (http://blog.thinknewfound.com/your-port folio-unhedged/).

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Hank Paulson, hero?

Felix Salmon
Sep 12, 2013 22:22 UTC

1338_cov304x4151.jpgHank Paulson had a good crisis. That’s why he’s getting hero-worship on the cover of Bloomberg Businessweek magazine; he is also pretty much the sole interviewee in a hagiographic 90-minute documentary, produced by Bloomberg, which is about to appear on Netflix. The combination is being promoted with the idea that “no one felt the impact” of the financial crisis more than Paulson, which is obviously false, but which also gives a pretty good idea of the whole project’s point of view. (The film never mentions, for instance, that Paulson received more than $500 million, tax free, for his Goldman Sachs stock when he sold it before moving to Treasury.)

Paulson has an interesting take on the various ways in which the crisis could have gone worse. First there was Bear Stearns: if he hadn’t managed to rescue the bank by finding a buyer in JP Morgan, says Paulson, then the chain reaction would have started. “If Bear Stearns had gone, then Lehman would have gone immediately thereafter, and we hadn’t fixed Fannie or Freddie yet. We would have had Armageddon”. The Bear rescue, according to Paulson, bought precious months during which Paulson could deal with Frannie, and during which Ben Bernanke could start setting up the various borrowing windows and liquidity programs which would help to stabilize the financial system.

Paulson also says, in the documentary — and this is a theory I haven’t heard before — that we would have been worse off if Bank of America had bought Lehman Brothers. If that had happened, he says, then there wouldn’t have been any buyer left for Merrill Lynch — and Merrill’s implosion would have been much worse than Lehman’s was.

It would be nice to see these claims — and Paulson’s tenure more generally — interrogated impartially by the Bloomberg Businessweek editorial machine, which is pulling out all the stops in terms of publicizing its Paulson extravaganza. (It’s even roping in Mike Bloomberg himself, something which has never happened before.) But with a documentary director who now considers Paulson to be “a national hero”, and a cover story which bears Paulson’s own byline, the former Treasury secretary was never going to be facing any tough questions.

To their credit, on the other hand, Bloomberg invited me to a promotional lunch with Paulson today, and so I took the opportunity to ask him about the perception that he always thought that he knew best, and that he considered popular opinion, and elected representatives, as annoying obstacles.

Paulson replied by saying that he “could not take greater exception with your comment”. He talked at some length about how he used his Goldman-honed client-schmoozing skills to get what he wanted from Congressional representatives on both sides of the aisle, but I must admit that I didn’t come away from his answer feeling as though he really respected those people’s views, or the importance of public opinion. And I’m perfectly happy to defend the argument that the arrogance of Paulson asking for a $750 billion blank check by presenting a three-page TARP bill was a significant reason why that bill was defeated.

I’m also happy that I got to ask Paulson about the secret meeting he held with the Goldman Sachs board in Moscow in June 2008. Even at the time, Paulson’s advisers thought it unwise; with hindsight, it seems indefensible. What could he have been thinking? But Paulson was unapologetic: “The incident you referred to was totally and completely appropriate,” he told me. “With a board of directors, people I hadn’t seen for years, I went to a social function with them, when we were in the same hotel, and said hi, and saw old friends”.

I don’t blame Paulson for the financial crisis; he was a good crisis manager — certainly better than either of his predecessors would have been — and he worked extremely well with Ben Bernanke and Tim Geithner. Still, everybody made mistakes during those long sleepless weeks, and it would be nice if some of the principals were more willing to admit that. And I also look forward to rather harder-hitting documentaries from Bloomberg in the future. This one feels altogether too promotional — both of Paulson and of Bloomberg Businessweek itself. The film is basically just one long interview with Paulson, intercut with a few words from his wife, and quite a lot of contemporary news footage and headlines. Including, notably, this anachronism:

Screen Shot 2013-09-12 at 4.42.30 PM.png

This story came out in November 2008; Bloomberg didn’t buy Businessweek until October 2009. Both Bloomberg Businessweek and Hank Paulson have a lot of good qualities. But this film does end up feeling as though it’s trying a bit too hard to make them both look good.


Caught that current Bloomberg magazine cover of Paulson trying to look like some kind of beleaguered tough-guy poor heroic Hank under siege but toughing out his super-lucrative Post-Treasury/Post Goldman idle time…

Plus his kissy-face interview with his fully-disclosed good buddy Charlie Rose, along with the very weaselly Bloomberg magazine editor plus the equally in-the-Paulson-tank documentary director.

Seems there’s a Hanky Paulson p.r. clean-up campaign underway, “poor tough Hanky saved the planet” back in 2008 when really he just happened to be the guy who had Congressional members always seeking post-gov’t jobs and lucrative post-Gov’t careers/consultancies trying to stay on Hanky’s good side.

To this day, as the NY Post’s John Crudele reminds and attempts to gain access to the gov’t docs. How Hanky during the crucial days in SEPT/OCT 2008 spent numerous – scores – of yet-undisclosed/undefined phone conversations with his Goldman Sachs CEO successor, Lloyd Blankfein. Gee, wonder what these two apparent connivers were talking about that no one else knew, or likely won’t ever know?

Then there was the disgusting image of Hanky-boy joking about how he literally – literally – knelt at the expensively-shod feet of then-House-Speaker Nancy Pelosi as Hanky-boy desperately sought unimaginably huge sums of taxpayer funds and almost singular control over same.

And ol’ Hanky-boy wasn’t so shameless to seem to seek direct bailouts for Goldman and his other banking buddies (except of course Dickie Fuld, whom evidently Hanky-boy had some sort of snitty disdain for).

No, Hanky didn’t seek direct bailouts for his banking buddies. Instead, he coyly and Pelosi-foot-kissingly sought to bailout the bankers’ COUNTERPARTIES, mainly AIG, and that way, AIG took the heat and Goldman et al and some of Hanky-boy’s other favorites got bailed.

As an ardent FREE-MARKET advocate, it’s increasingly disgusting to see these kinds of oligarchic set-ups whereby you have Wall Street heavyweights revolving into and out of high, super-influential gov’t offices. Robert Rubin, Jacob Lew, Timothy Geithner, Paulson, and a truly cretinous exemplar of the breed: Jon Corzine.

On top of everything else, these “hotshots” like to run around claiming they’re the “smartest guys in the room,” yeah, it’s easy to be “smart,” when you have access to untold sums of that other slimey favorite tactic, “other people’s money” – especially taxpayers. And another Hanky-boy tactic is to come across as some kind of mumbling, down-home aw-shucks humble little me. Like Corzine, Lew, Rubin et al instead he is a relentless practitioner of taking often senseless risks with other peoples’ funds.

These “smart guys,” increasingly put not just the economic health of the nation at risk, they’re inviting the kind of oppressive regulation that risks curtailing the free-market’s highest ideals and benefits.

And let’s not even get started about how a lot of these cats belong in jail for long periods of time. And keep in mind in China, and self-described “Chinese expert” Hanky-boy should realize this. In China, they sometimes SHOOT those convicted of rank corruption. DickSheppard-Jersey City, NJ

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Regulatory arbitrageurs of the day, insurance edition

Felix Salmon
Sep 12, 2013 14:21 UTC

Well done to Benjamin Lawsky, who is getting serious about the regulatory arbitrage which is endemic in the insurance industry — or, as he put it in a powerfully-worded letter yesterday, “the gamesmanship and abuses associated with the setting of reserves”.

The topic here is decidedly gnarly, but also extremely important. Insurance companies, just like banks, have both assets and liabilities. Their assets are generally financial investments (stocks, bonds, private equity limited partnerships, that kind of thing) — and therefore pretty easy to calculate. Their liabilities, on the other hand, are fuzzier: at some unknown point in the future, they’re going to have to pay out some unknown sum of money to an unknown number of insureds claiming on an unknown number of events.

Take life insurance, as an example: everybody dies. But that doesn’t mean all life insurance policies pay out: many of them expire before their holders do. And in general, the longer that you live, the more money that your life insurer will be able to make before having to pay out on your policy. And as with most other forms of insurance, life insurance is prone to black-swan events. US life insurers, for instance, dodged a bullet during the AIDS crisis: they were incredibly lucky that the disease hit populations — intravenous drug users, gay men — who tended not to hold much if any life insurance. If AIDS had hit young professionals with families instead, then it’s entirely possible we would have seen a mass of insurers going bust.

A money manager once told me that all insurers go bankrupt eventually; it’s just a question of when. If you insure property then a hurricane or earthquake will come along; if you insure cars then they’ll get hit by a freak hailstorm. And of course all insurers are exposed to market risk: if the value of their investments plunges sharply, then they’re suddenly much less able to meet their obligations going forwards. He might have been exaggerating a little for effect, but his point is well taken — and helps to underscore why it is crucial that the insurance industry be closely and independently regulated.

Which, needless to say, it isn’t. Mary Williams Walsh has the background to the latest war of words, which is taking place between Lawsky, who is New York State’s top financial services regulator, and his counterparts in other states. In a sense, you don’t even need to know the substance: all you need to know is that if you live in a country which has 50 different insurance regulators, and no real federal oversight of what they’re doing, then it’s inevitable that some states will have laxer regulation than others — and that the big insurance companies, no matter where they’re physically located, will manage to come up with a way of doing lots of business in those states.

Which is exactly what has happened. An insurer in New York, or Connecticut, can set up what’s known as a “captive”: it can reinsure its own risks (which is normally a good thing) — except it owns the company it’s moving those risks to. Naturally, these captive reinsurers are all located in jurisdictions with lackadaisical regulatory oversight.

As Lawsky points out in his letter, this is just like the SIV nightmare we all went through five years ago: financial institutions are nominally moving risk off their own books, even though, when push comes to shove, they’re still ultimately responsible for it.

The parallels don’t end there. There were two main types of regulatory arbitrage which helped to cause the financial crisis. One was the SIVs; the other was Basel II, which allowed banks to basically determine for themselves how much capital they should hold. (Surprise: the answer turned out to be “not very much”.) In the wake of Basel II, you’d think that such outsourced regulatory regimes were a thing of the past — and you’d be wrong. The insurance-industry version of Basel II is called “principles-based reserving“, or PBR. In practice, it has done exactly what Basel II did: it has allowed insurers to reduce the amount of capital they need.

Lawsky is fed up with all this, and is withdrawing from all attempts to implement PBR; good for him. But so long as the fractured regulatory regime remains in place, Lawsky’s actions will not have much effect on the insurance industry more generally. We desperately need a national insurance regulator, and we need one with some spine. Otherwise, we’ll continue to live in a world with the unedifying spectacle of companies like MetLife saying with a perfectly straight face that they need to set up captive reinsurance companies, rather than simply hold more capital, because “using equity could reduce returns to levels below those required by investors”.

If life insurers dodged a bullet during the AIDS crisis, then all of America — indeed, the world — dodged a bullet during the financial crisis, when any mark-to-market analysis of insurers’ balance sheets would have showed them to be mostly insolvent. Luckily for all of us, the markets rebounded, and the insurers are now, financially, much healthier than they were. The problem is that their financial health will inevitably leach away into their shareholders’ pockets, unless strong regulators prevent that from happening. Lawsky is leading the way, here. If we ever do get a national insurance regulator (and I’m not holding my breath) then he’d be a good person to lead it.


dsquared – that logic applies to every company, whether an insurer, some other type of financial firm, or a non-financial manufacturing or service company. The probability of any company becoming bankrupt in a given timeframe is north of zero, so over a long enough period of time it approaches 100%. Not sure if that tells us much beyond placing value on dividends and remembering the uncertainty of long-term forecasts.

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Verizon datapoints of the day

Felix Salmon
Sep 11, 2013 19:54 UTC

The big financial news of the day is the Verizon bond issue, and Reuters (or rather our sister publication, IFR) is all over it. The most awesome aspect of the deal is its monstrous size: $49 billion, across eight different tranches, from three years out to 30. The biggest tranche, the 30-year, is $15 billion on its own, and priced at 265bp over Treasuries: that works out to a very tasty 6.5% yield. No wonder the deal was oversubscribed, and that the bonds have been tightening sharply in the secondary market.

Verizon is paying eye-watering sums of money to get this deal done. Wall Street’s fees alone will probably approach $1 billion: some $500 million just for M&A advice, plus the fees on the $61 billion bridge loan (call it $200 million right there), plus the fees on $49 billion in bonds (another $300 million, probably).

And then there are the hidden fees, which are bigger still. If Verizon raises $49 billion and then the bonds trade in by 40bp, the investors in those bonds will have made billions of dollars, in mark-to-market profits, over the course of one day. To give just one example: a 30-year bond with a 6.5% coupon, if it’s trading at 6.1%, corresponds to a price of $105.48. So if investors spend $15 billion on such bonds at 6.5%, and then those bonds tighten to 6.1%, then the investors who got in on the bond will make a one-day profit of $822 million. And that’s just one tranche, corresponding to roughly 30% of the total financing.

Every time that a high-profile IPO soars on its debut, there’s a debate about whether the company got shafted, and whether the underwriters fundamentally mispriced the deal. But in this case, we’re not just talk about foregone theoretical proceeds: we’re talking about real cash, which Verizon is going to need to pay out to bond investors for decades to come. The $15 billion 30-year bond will pay a total of $29.25 billion in coupon payments over its lifetime; if it had come at a yield of 6.1%, that number would have been $27.45 billion — a savings of $1.8 billion in cash. And again, that’s just one tranche.

Which is not to say that the Verizon deal was mispriced. Everybody on Wall Street knew that Verizon had to raise this money, and so they made it as expensive as possible for Verizon to do so. It’s the first rule of fundraising: you can only raise cheap money when you don’t need it. When you do need it, you’re going to pay up. Especially when you need to raise the sheer quantity that Verizon was asking for here.

It’s hard to put $49 billion in context: few numbers, in the real world, are remotely that big. (Take Yankee Stadium, fill it to capacity, and give everybody in it a million dollars — you’re basically there.) As a result, journalists have a habit of moving to GDP numbers. IFR says that $49 billion is “larger than the GDP of some 90 countries”, while Business Insider, inspired by Ben Eisen, helpfully provides a list of some of those countries. (Luxembourg! Honduras! Afghanistan!)

The problem is that the $49 billion is not the same thing as what you might call Verizon’s gross corporate product. The comparison isn’t quite as bad as the typical stock-versus-flow solecism (saying, for example, that Stanford’s endowment exceeds the GDP of Jamaica), but it’s still not a good one. If you want to compare Verizon to a country, you should be looking at Verizon’s revenues — which are in the $115 billion range — rather than its borrowings.

Still, the national comparison is worth making, because if Verizon is borrowing $49 billion on revenues of $115 billion, that means that this single deal is roughly equivalent to a sovereign country going out into the markets and borrowing 42% of GDP in one stroke. Of course, companies can dedicate more of their revenues to debt service than countries can. But I spent a bunch of time playing around with World Bank data this morning, to see which countries have tax revenues in the neighborhood of $115 billion. The answer: $115 billion is more than the tax revenues of Colombia, Taiwan, Greece, or Israel, and is roughly double the revenues of New Zealand. It’s real money.

Verizon is huge. With about 200,000 employees, if you include all their families, you’re pretty much at the total population of Luxembourg. Verizon Wireless has over 100 million customers; today’s bond issue works out at about $450 per customer. It’s a lot of money, but Verizon can afford it. Mobile communications are the defining characteristic of the world we’re living in, and Verizon is one of the global giants in the sector. Even with its massive new debt load, its prospects are a hell of a lot rosier than those of Greece.



Verizon has been trying to stick it to customers by raising prices and by eliminating unlimited data. On September 25th, my wife’s contract with Verizon termanates (after 7 years with the company). On September 26th (or soon after), she will switch to a new carrier.

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Annals of ignoble cowardice, Second Circuit edition

Felix Salmon
Sep 10, 2013 07:35 UTC

I spent all of yesterday at a fascinating and wonky conference in London, on the economics and law of sovereign debt. I gave a short talk on the latest developments in Elliott vs Argentina (a/k/a NML vs Argentina), and specifically on the decision which was handed down by the Second Circuit court of appeals on August 23. These are the notes I drew up for the talk.

And now abide faith, hope, love, these three; but the greatest of these is love.

We’ve all heard these words at weddings, and even sometimes at funerals. But I’ve written my own version, just for pari passu geeks. It goes something like this:

And now abide secured, unsecured, judgments, these three; but the greatest of these is a judgment.

I am not a lawyer. But maybe because I’m not a lawyer, I feel like I can look at what’s going on in the NML vs Argentina case from a little bit of a distance. And when I do that, what I see is a series of court decisions which have undermined the very way in which debt is understood to work.

Remember that pari passu, at heart, is all about ranking; it’s about seniority of payment. And the way I see it, seniority works in a pretty well-established way. First of all, there’s unsecured debt. Mitu lends me money, and now I owe him a certain sum on a certain date. It’s pretty simple. If I pay him, he’s happy; if I don’t pay him, he’s sad.

Next up, there’s secured debt. Henrik lends me money, but he’s worried that I might not be able to pay him back. So he insists on a lien: he wants me to put up my country house as collateral. As with Mitu, I still owe Henrik a certain sum on a certain date. And as with Mitu, if I pay him, he’s happy. But if I don’t pay him, he goes straight to plan B: he seizes my country house, sells it, and uses the proceeds to ensure that he’s repaid in full. Still, Henrik can still end up unhappy. If I don’t pay him, and if my country house has burned down, then there’s nothing to seize, and he ends up where Mitu was, holding a defaulted obligation.

This is where the courts come in. Once I’m in default, any of my creditors — Mitu, Henrik, Joseph, it doesn’t matter — can go along to a court and reduce their obligation to a judgment. And judgments are very powerful things. Because once you’re armed with a judgment, you basically become an ultra-secured creditor. If I own a country house, you can forcibly attach that, and sell it, and pay yourself from the proceeds. But if my country house has burned down, you can attach any of my other possessions instead — you can attach my stock portfolio, or my wine cellar, or even, most simply, my bank account. Anything I own, if it can be reached by the long arm of the law, is now within your grasp.

There are only two ways for me to foil you, if I have assets and you have a judgment. The first is for me to declare bankruptcy. But for the sake of argument, let’s say that bankruptcy isn’t an option. Maybe my assets vastly exceed my liabilities. The second is for me to somehow move my assets to where they can’t be touched by your courts. Maybe I smuggle my stamp collection into a safety deposit box in Iran. It’s not going to do you much good there, because your judicial system isn’t going to be able to extract it from that box and sell it.

Still, even if you have a judgment, you can’t attach what isn’t mine. For instance, let’s say that Joseph has a bank account. If I owe Mitu money, even if he’s armed with a judgment, he can’t barge in and attach Joseph’s bank account. Just mine.

Now it’s true that I borrowed money from Mitu and from Henrik, and that I defaulted on both of those loans. I borrowed money from Joseph, as well. Joseph has something weird — he has something called subordinated debt. In his loan documentation, it explicitly says: “I will not pay you any money unless and until I’ve paid Mitu first. Mitu is senior, and you, Joseph, are junior.”

So when I default on my obligation to Mitu, Joseph is also sad: he knows that he’s junior to Mitu, which means that I’m not going to be paying my subordinated creditors any time soon.

But when Joseph’s coupon date rolls around, guess what? I walk into his bank, take out a wad of cash, and tell the bank to deposit into Joseph’s account every penny that he’s owed. Now, Joseph is happy: he’s just received an unexpected windfall. And Mitu is furious, because he knows what I promised Joseph.

Mitu has been patient with me, so far, but now his patience has run out, and finally he decides to go to court. “I have a piece of paper here which clearly says that I’m a senior creditor,” he tells the judge. “And Felix is going and paying his junior creditors, without paying me!”

The judge is sympathetic, and wants to help out Mitu in any way he can. “I’ll tell you what,” he says. “I’ll give you a judgment, that’s what judges do. And then, armed with that judgment, you can attach anything that Felix owns, and use those assets to pay yourself everything you’re owed.” This mollifies Mitu, because he knows that judgments are the best thing you can have. But it takes time to locate and attach assets, and when Joseph’s next coupon date rolls around, I go and do exactly the same thing: I walk into Joseph’s bank, and tell them  to deposit a bunch of money into Joseph’s account.

Now Mitu is really hopping mad, and he goes back to the judge, who is still sympathetic. But then Mitu goes too far. He asks the judge to bring down a judgment not on me, but rather on Joseph. “Tell Joseph that he owes me the money,” says Mitu. The judge is a bit puzzled. “Does Joseph owe you money?” he asks. “Where do you have a contract with Joseph?”

“Oh,” says Mitu. “Good point. I don’t have a contract with Joseph, I only have a contract with Felix. So you can’t tell Joseph that he owes me money. But hang on, I have another idea. I can see what Felix is doing now: he’s paying Joseph, without paying me. So I want you to go to Joseph’s bank, and tell them that the next time Felix deposits money into Joseph’s account, they should refuse to do that.”

Now the judge is really puzzled. “Joseph’s bank?” he says. What have they got to do with anything? They’re just the institution which looks after Joseph’s money. And in fact, they have a very clear contract of their own, with Joseph, and they don’t have any kind of contract with you. Felix promised to pay you money, and he broke that promise, and I’ve given you a powerful judgment saying that Felix owes you money. But neither Joseph nor Joseph’s bank owes you money, so I’m not going to start slapping injunctions on them.”

Mitu is unimpressed. “But Felix promised that he wouldn’t pay Joseph without having paid me first!” The judge, on the other hand, is equally unimpressed. “Yes, Felix broke his promise. Felix broke his promise the minute that he defaulted on his payment obligation to you. He has since broken another promise. And he can go head and break a thousand more. When Felix breaks his promise, I enter a judgment against Felix. I’ve done that. But I’m not going to start handing down judgments on Joseph, or on Joseph’s bank, just because Felix has broken a promise. Those guys are independent actors, and have no control over what Felix does. So leave them alone.”

Most of the time, this story works out quite well for Mitu. Because my assets exceed my liabilities, and because Mitu has a judgment against me, it’s not hard for him to get satisfaction. But regardless of whether Mitu ends up being satisfied or not, the principle is clear. The remedy, if I break my contractual promise, is that my creditor can get a judgment against me. And a judgment is to all intents and purposes the most senior claim that anybody can have.

This is why I find the behavior of the judges in New York to be so bizarre. Firstly, they have turned the natural order of creditors on its head. Secured, unsecured, judgments, these three; now the greatest of these is, bizarrely, unsecured, with a pari passu clause. It’s the unsecured creditors who are being able to get remedies which — at least so far — have proven unavailable to either secured creditors or judgment creditors.

Secondly, there’s no real logic to how this new system of jurisprudence should be enforced. It seems to me that if Joseph has explicitly subordinated debt, and Mitu goes to court, then Mitu is going to come away empty-handed, because the explicit subordination is in Joseph’s bond documentation rather than in Mitu’s. But if Mitu manages to find the right flavor of pari passu clause in his own documentation, then suddenly everything changes, and the nuclear remedy becomes magically available.

Thirdly, the judges have created a new class of activity, for debtors, which is Worse Than Default. It used to be that when it came to debt contracts, defaulting was the worst thing you could do. That’s no longer the case: now, the worst thing you can do is to selectively default. In other words, if I pay Joseph and don’t pay Mitu, that’s considered worse than if I don’t pay Joseph and don’t pay Mitu. Because only in the first case — only when I’m in partial default — will New York’s judges roll out their brand-new thermonuclear remedy.

Fourthly, it is now entirely acceptable, under New York’s system of jurisprudence, for judges to punish the innocent, rather than the guilty. Neither Bank of New York nor the exchange bondholders have done anything wrong. All they’re doing is collecting the money they are rightfully owed. But if these rulings stand, they won’t be allowed to do that any more.

This is the bit which annoys me most about the Second Circuit’s ruling. The courts are clearly punishing the innocent, with these rulings, and yet are bending over backwards to pretend that they’re not. If you’re going to do something as unintuitive as this — if you’re going to make unsecured non-judgment creditors effectively the most senior, and create a brand-new nuclear remedy, and punish the innocent, and violate a whole bunch of sovereign-immunity precedent while doing so — then at the very least you should be open and honest about what you’re doing and why you’re doing it.

Instead, the rulings of both Judge Griesa and the Second Circuit are run through with pinched and disingenuous legal reasoning. They refuse to step back and take responsibility for the big-picture consequences of their actions, and it’s that, to me, which is by far the worst thing they’ve done. I have precious little sympathy for Argentina, in this case, and not much for Elliott Associates either — but at least both of them are openly and honestly making the best case they possibly can for their actions. The New York courts, by contrast, are just being poltroons, and it’s their ignoble cowardice which really drives me up the wall and which is the main reason the Supreme Court should accpet this case and decide it head on.

I can understand the pique and frustration which led Judge Griesa to enter his original judgment against Argentina. When an actor in your court is being as consistently and unapologetically contumacious as Argentina, eventually you reach breaking point. But when that kind of thing happens, it’s the job of the appeals court to provide cooler heads, and to say hang on a minute, what are we doing here, are we sure we really want to go down this road. Especially when you’re the court which has for decades looked after the New York payments system and the US financial architecture.

But that’s not what the Second Circuit did. Instead, they ducked all the big questions, and decided this case as narrowly and pedantically as they conceivably could. Which is why they — much more than Elliott Associates, or Argentina, or anybody else — are the biggest villains of this story. Of all the actors on stage, it’s the Second Circuit which has acted in the worst faith. I hope — against hope — that the Supreme Court will hold them to account for their actions.


A owes B and C money equally. A decides not to pay B or C unless they take a haircut. C agrees to take a haircut, but B does not. Furthermore, C knows that B will not take a haircut.

If A tries to pay C, but not B: C cannot claim to be an innocent.

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Fuzzy credit

Felix Salmon
Sep 8, 2013 22:52 UTC

Matt Levine, newly arrived at Bloomberg View, has a very smart response to my post about those weird jumbo mortgage rates. Levine comes up with two reasons why jumbo rates might be lower than the rates on loans which can be sold to Frannie, and both of them are entirely plausible.

The first is that credit risk on conforming mortgages doesn’t simply disappear just by dint of those mortgages being sold to Frannie. The agencies need to charge a fee to cover the credit risk on the mortgages that they’re buying, and that fee is going to find its way, one way or another, into the yield on conforming mortgages. Since it stands to reason that the credit risk on conforming mortgages is greater than the credit risk on jumbo mortgages (on the grounds that rich people, in general, are more creditworthy) then it similarly makes sense that the all-in yield on conforming mortgages might be higher too.

Levine’s second hypothesis is related to the fact that bonds in general, and agency bonds in particular, are instruments which are marked to market daily — while jumbo loans are long-term assets which can sit on a bank’s balance sheet for decades, through many credit cycles. If a bank buys mortgage bonds, notes Levine, then it is obliged to mark them down, taking a hit to its P&L, if and when mortgage rates rise. Actual mortgages, on the other hand, not being marked to market, never need to suffer such markdowns. And that makes them more attractive. Conforming mortgages will always end up being priced off the market, and during times when banks expect interest rates to rise, the market might well be quite expensive, compared to loans which are designed to be held to maturity.

P1-BM974_JUMBO_NS_20130904190909.jpg.CROP.original-original.jpg Both of Levine’s ideas are pretty good ex post explanations for why jumbo mortgage rates might be lower than the yield on agency bonds. But Levine — along with Matt Yglesias, and myself — failed to ask the most obvious question: are jumbo mortgage rates, in actual fact, lower than the rates on conforming mortgages? It certainly looks that way, in the WSJ article. But then I got a very interesting email from Keith Gumbinger, of mortgage-rate information service HSH.com.

The WSJ’s Nick Timiraos cites some data about the spread between the two rates from HSH, but his chart uses information from the Mortgage Bankers Association. And what Timiraos never says is that if he just stuck to HSH data throughout, the spread would never have turned negative.

Part of the problem is that there’s no such thing as a simple, commodity mortgage. These things are all pretty complex beasts, and most of them include the borrower paying “points” up front, which need to be converted into percentage points using a rule of thumb like four “points” = 1 percentage point. According to HSH’s data, jumbo mortgage rates were actually closer to 4.86% last week, a full 15 basis points more than the WSJ’s 4.71% figure.

On top of that, according to HSH, the MBA figures used by the WSJ show conforming mortgage rates about 12-15bp higher than the figures coming out of both HSH and Freddie Mac.

In other words, use a different dataset, and you don’t see the crossover phenomenon at all. Gumbinger has a few ideas about why the MBA’s data might be such an outlier; one reason, he says, is that the MBA counts all mortgages of more than $417,000 as jumbo mortgages, even when they’re in markets like New York and Los Angeles where mortgages can be conforming when they’re as large as $625,500. Additionally, he says, the MBA rates reflect actual quoted mortgage rates to borrowers — which means that if borrowers are becoming less creditworthy for whatever reason, the rise in conforming rates might not really be comparing apples with apples. For a borrower of given creditworthiness, mortgage rates won’t have risen as much as the WSJ chart shows.

All of which is symptomatic of a broader truth: the minute you start seeing headlines about some yield trading through some other yield, be suspicious. Fixed-income instruments, be they bonds or loans, tend to be extremely illiquid, and although a chart can make it seem as though they’re priced and traded to the nearest basis point, in reality their pricing is much, much fuzzier than that. Outside Treasury bonds and the primary market, it just doesn’t make sense to talk about “the yield” on a certain credit, or “the price” of a certain bond: when there are generally dozens of different instruments outstanding, none of which trade very much, the price and the yield are pretty much whatever you want them to be. You might be able to get a vague idea of the range in which they’ve been trading, but we’re not talking about things like stocks, here, where the price at any given point in the day can be nailed down to the nearest cent.

A more realistic chart, then, from the WSJ, would have shown a wide and fuzzy green line, and a wide and fuzzy blue line, and those two lines coming closer to overlapping a little bit. In fact, all charts of secondary-market credit spreads should look like that. (Mortgage rates are primary market, not secondary market, but the principle is the same.)

In a ZIRP world, it’s easy to get excited about a couple of basis points here or there. But before you do, remember the error bars. Because yields on any credit product are ultimately Heisenbergian: the closer you look, the harder they are to nail down.