John Jansen reprints some BarCap research on the Miller-Moore amendment, and now I think I understand why so many finance types are so scared by it: they’ve misread it!

Here’s BarCap:

Proposed by Reps. Miller (D) and Moore (D), it would effectively replace existing repo and secured funding with unsecured borrowing subject to a margin, or haircut, of up to 20%. Specifically, in the case that a large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%…

No secured lender will want to be left in a trade with a bank in receivership where the regulators have converted the transaction into an unsecured loan at 80% of the original amount.

But that’s not what the amendment is proposing. Here it is:

An allowed claim under a legally enforceable or perfected security interest (that became a legally enforceable or perfected security interest after the date of the enactment of this clause), other than a legally enforceable or perfected security interest of the Federal Government, in any of the assets of the covered financial company in receivership may be treated as an unsecured claim in the amount of up to 20 percent as necessary to satisfy any amounts owed to the United States or to the Fund. Any balance of such claim that is treated as an unsecured claim under this subparagraph shall be paid as a general liability of the covered financial company.

Let’s say you have a secured claim of $1 million on a bank which has been taken over by the FDIC, and let’s say that unsecured creditors of that bank end up being paid only 70 cents on the dollar.

If the BarCap reading were right, the FDIC would first impose a 20% haircut on the $1 million, turning it into $800,000, and then convert it into an unsecured loan — which, at 70 cents on the dollar, would be worth just $560,000. The net effective haircut would be a whopping 44%. But of course this makes no conceptual sense at all, because unsecured creditors would end up being treated better, under this scheme, than secured creditors.

The way I read it, however, the Miller-Moore amendment allows up to 20% of the secured debt to be converted into unsecured debt; the rest of it is untouched. So you retain $800,000 of secured debt, worth $800,000, and now the remaining $200,000 is unsecured debt, worth $140,000. All in all your $1 million claim is worth $940,000 — a net effective haircut of just 6%.

No one likes losing 6% of their money, of course, but that’s a hell of a lot better than losing 44% of your money. And maybe if the sell side begins to understand how Miller-Moore really works, they might be less averse to it.

(HT: Alloway)

Ira Stoll notes that the Miller-Moore amendment has passed. He calls it the “Bair-Miller-Moore Haircut”, and he doesn’t like it; I, on the other hand, think it’s a spectacularly good idea. This is the meat of it:

Payments to Fully Secured Creditors: Notwithstanding any other provision of law, in any receivership of a covered financial company in which amounts realized from the resolution are insufficient to satisfy completely any amounts owed to the United States or to the Fund, as determined in the receiver’s sole discretion, an allowed claim under a legally enforceable or perfected security interest (that became a legally enforceable or perfected security interest after the date of the enactment of this clause), other than a legally enforceable or perfected security interest of the Federal Government, in any of the assets of the covered financial company in receivership may be treated as an unsecured claim in the amount of up to 20 percent as necessary to satisfy any amounts owed to the United States or to the Fund. Any balance of such claim that is treated as an unsecured claim under this subparagraph shall be paid as a general liability of the covered financial company.

In English, this means that if you’re a secured creditor of a bank which has failed and which the federal government has to pay money to rescue, you are only guaranteed to receive 80% of your money back. Beyond that, you’re treated as an unsecured creditor.

This achieves three important goals.

Firstly, it means that lenders to dodgy banks will actually have to start doing underwriting, rather than simply relying on their security interest. That keeps everybody honest, and will give the system a heads-up when banks start getting into trouble.

Secondly, it means that wholesale lenders no longer have the ability to jump the queue when it comes to seniority. Banks should repay their depositors first, and then their senior unsecured creditors, and then their subordinated creditors, and then their preferred shareholders; whatever’s left over goes to common shareholders. But increasingly the pecking order has been upended by allowing banks to issue secured debt, which in practice ends up being senior even to depositors. In some countries, banks aren’t allowed to issue secured debt at all; this amendment doesn’t go that far, but at least it makes the debt a little bit riskier for the lender.

Thirdly, it means that banks will be forced to look at the big picture when it comes to their assets, rather than simply using them as collateral for cheap and dangerous short-term funding. Writes Stoll:

The provision make it harder and more expensive for banks to raise capital, and therefore, harder to get credit flowing again into the economy.

This is not entirely true. The provision makes it harder and more expensive for banks to raise secured capital — but as we’ve seen, there are lots of other funding sources available to banks. The more unpledged assets that a bank has, the easier it is for that bank to raise both unsecured debt and various forms of equity.

Conceptually, this is entirely what we want. If I have an asset worth $1 million, I can either borrow $900,000 against that asset and pay interest on the loan, or else I can sell off equity stakes in that asset for $1 million. I’m not sure why the former is a better idea than the latter, when we’re trying to deleverage the banks and move to a more equity-based (and less debt-based) world.

Does the Miller-Moore amendment make banks more liable to liquidity runs? Yes, but on the understanding that (a) they only become more vulnerable insofar as they’re reliant on the short-term repo markets, which is something we want to discourage; and (b) they have access to the Fed’s discount window anyway, so it’s not as though all secured funding sources can disappear overnight.

Why does Stoll love secured creditors so much? He says that “the rights of secured creditors took a beating in the Chrysler bankruptcy” — but that’s not true. They still had the right to provide DIP financing themselves (the role played by the government) or even to push Chrysler into liquidation. They sensibly didn’t exercise those rights, because doing so would have cost them an enormous amount of money compared to what they ended up getting. But the rights themselves were untouched.

The Miller-Moore amendment, by contrast, really does hit secured creditors. That’s a very good idea. Next up, let’s allow bankruptcy judges to modify mortgages, too.

Update: One more thought on this subject. Most secured funding for banks comes from the repo market, where banks borrow against securities they own. But what are banks doing holding so many securities in the first place? Shouldn’t their assets mainly be loans, which can’t be repoed?

Bill Gross isn’t earning much interest on his cash: in fact, he’s only earning 0.01%. Tell us, Bill, what’s an appropriate metaphor to explain how it feels to earn such a low interest rate?

My point is to recognize, and to hope that you recognize, that an effective zero percent interest rate, as a price for hiding in a foxhole, is prohibitive. Like the American doughboys near France’s Maginot line in WWII – slumping day after day in a muddy, rat-infested pit – when the battalion commander finally blew his whistle to charge the enemy lines, it probably was accompanied by some sense of relief; anything, anything but this! Anything but .01%!

I’m not sure this is entirely fair. Think of the camraderie in those muddy foxholes! Think of all those meaningful religious conversions! Frankly, earning 0.01% interest on your money-market funds is much worse than that!

Or, you know, it could be a sign of how incredibly short memories are. A year ago — even six months ago — people thought that losing 30% or 40% or 50% of your money constituted something extremely painful. Now, it seems, making a small amount of money is analogous to fighting in the bloodiest war of all time.

Kid Dynamite today translates Gross’s column into Sensible, explaining that opportunities paying say 5% annualized become a lot more attractive when rates are at zero than they are when you can get 5% just by investing in Treasury bills. Hence assets yielding anything at all — even stocks — have become pretty popular of late, accounting for the impressive price rise since March. Still, he concludes, “this can only end one way… badly”. People aren’t asking that yields compensate for risk any more, they’re just asking that they pay more than nothing. Which is probably not the smartest manner of allocating capital ever invented.

As for Gross, his best advice is to buy utility stocks:

Pricewise, they’re only halfway between their 2007 peaks and 2008 lows – 25% off the top, 25% from the bottom.

Is that the new Goldilocks Scenario, I wonder?

Update: The quote above — which mangles history in unspeakable ways, as many commenters noted — has been changed on the Pimco website, which now talks about “the American doughboys near France’s future Maginot line in WWI”.

Megan McArdle is cutting up her credit cards, but she doesn’t want to force anybody else to do the same thing. She responds to my sentiment that credit should come from loans, not cards, thusly:

I don’t think personal loans are a very good substitute for the kinds of emergencies that frequently beset the people who this would most effect–if your car breaks down and you can’t get to work, you don’t really want to wait until the bank approves your personal loan to get the car fixed. But there are a lot of people who think we could make the poor better off by essentially denying them access to credit, because credit extended to the poor carries high interest rates to cover the default risk, and many people get themselves into big trouble with it.

The problem is, there are two sets of outcomes. There are people who are made better off by payday loans or credit cards, because they get the car fixed and don’t lose their job. Then there’s a group, which seems to be smaller but significant, who end up much worse off.

McArdle is far too generous to the lenders here. For one thing, I made it clear in my post that credit cards are very good for transactional credit: if you need to pay the car-repair shop today, using a credit card is a great way of doing so. But you should also have a good enough relationship with your bank that by the time the credit-card bill comes due, you can pay it with the proceeds from a personal loan or line of credit.

Secondly, I don’t think for a minute that we should deny the poor credit; in fact I’m on the board of a non-profit institution which exists to provide credit to the poor, and I’m all in favor of that. It’s credit cards I don’t like, with their high fees and interest rates (and there are even exceptions to that rule, such as the ones provided by many credit unions). And I really dislike payday loans, which are pretty much universally predatory, especially when compared to similar products from community development credit unions.

Megan’s conceptual mistake here is clear when she says that “credit extended to the poor carries high interest rates to cover the default risk”. But in fact the interest rates on credit cards are really not a function of default risk at all. Mike Konczal had a great post on this back in May, where he showed pretty conclusively that credit-card interest rates were all about maximizing profit for the issuer, rather than compensating for default rates. And payday loans are even worse.

What earthly grounds does Megan have for saying that the number of people made worse off by payday loans is smaller than the number of people made better off by them? I suspect she considers the alternative to be no-credit-at-all-nohow-noway. But that’s not what anybody is proposing. I, for one, think that credit should be available to the poor, very much so. But not in the quantities and at the rates that it’s been available until now. There is such a thing as too much credit, and we crossed that line long, long ago.

Update: Megan responds. At length.

Philosophically speaking, why don’t we tax corporate interest payments? (Practically speaking, the answer is that it’s politically impossible.) So far, the answers have fallen into three broad categories.

The first one feels like a category error to me, and basically says “the corporate income tax is a tax on income, and a tax on interest payments isn’t a tax on income, so you can’t expand corporate income taxes to include a tax on interest payments”. Well, yes, if you taxed interest payments you’d be taxing something other than income. That’s the whole point. Private equity shops love to load so much debt service onto their portfolio companies that they never make a profit, and therefore never have to pay taxes. This is not something we want to incentivize. There are lots of non-income taxes in the US; this would just be another.

The second two answers are better. Kyle says that it would be almost impossible to build such a law without loopholes: “there are lots of ways to create debt like exposure that appear to be expenses”. And Megan McArdle writes that debt really is a legitimate business expense for certain companies:

Heavy industrial companies need more capital to make new investments, and it can make good sense to match the duration of the financing to the expected life of the asset. That’s accomplished by borrowing money, not floating a new stock issue or trying to accumulate enough retained earnings to keep up with your competitors.

Interestingly, these two objections seem to cancel each other out somewhat. If an industrial company wanted to finance the purchase of a major asset, it could simply sign a long-term lease instead, turning a taxable interest expense into a legitimate business expense. And it would be quite easy to say that leasing companies had to be part of federally-regulated bank holding companies (which would be exempt from this tax), and couldn’t be part of the same corporate ownership structure as the companies they were leasing to.

I agree with Megan that implementing this tax “would make companies that do use debt finance much more risky”. That’s the whole point. We want to move away from over-reliance on debt finance, and towards a world where equity finance becomes much more common and much more boring. If investors want to leverage corporate profits with debt they can do so themselves, by buying stock on margin. But let’s not implement the leverage at the corporate level, where it’s imposed on even the most risk-averse equity investor.

Update: Steve Waldman adds that what we’re talking about is eliminating a tax deduction, rather than imposing a new tax. A useful thing to bear in mind.

Three cheers to Jim Surowiecki for unambiguously adding his voice to those who would abolish the tax-deductibility of interest payments:

Debt didn’t get dangerously out of scale because the system was broken. It got out of scale, in part, because the system worked…

As much as possible, the tax system should be neutral between debt and equity, and between housing and other investments. It’s not, and, worse still, as we’ve seen in the past couple of years, debt magnifies risk: if companies or individuals rely on large amounts of leverage, it’s much easier for bad decisions to lead to insolvency, with significant ripple effects in the wider economy. A debt-ridden economy is inherently more fragile and more volatile.

The weird thing for me is that when I start banging this particular drum, I always get exactly the same answer: “yes, great idea, not gonna happen”. But is there any intellectual justification whatsoever for making corporate interest payments tax-deductible? I can see an argument for a carve-out for highly-regulated banks, since their entire business is based on making profits from the spread between the rate at which they lend and the rate at which they borrow. But banks aside, why should companies pay lots of tax on dividends, and no tax at all on bond coupons?

In a way it’s depressing: if this were a real debate and Paul Volcker had a remote chance of making interest taxation happen, then surely there would be no shortage of academics and corporate lobbyists making the case for keeping the status quo. The fact that they’re not even bothering is all the evidence we need that this isn’t even going to reach trial-balloon status, let alone get signed into law.

But still, the question remains: if they were to start taking this seriously, what arguments would they use? After all, as Surowiecki notes, the likes of Brazil and Belgium seem to do perfectly well without giving debt this artificial advantage.

Landon Thomas’s story on dodgy shipping loans has some absolutely astonishing numbers, the biggest of which is simply the size of the market, which he pegs at a whopping $350 billion.

The story is pegged to Eastwind Maritime, a shipper which went bust this summer owing $300 million on a fleet of 55 ships. That’s about $5.5 million per ship, which isn’t very much when the average five-year-old vessel was valued at about $88 million as of June of 2008. But things are different now:

Aozora Bank, a Japanese bank that in addition to being one of Eastwind’s top lenders is a major creditor of Lehman Brothers, found to its dismay that the value of the 12 Eastwind ships it now controlled was considerably lower than its $77 million exposure.

The biggest at-risk bank is German state-owned lender HSH Nordbank, with $50 billion of shipping loans. So far, it’s provisioned just $800 million of those, although it’s also received $19.4 billion in support from its shareholders, the regional German states of Hamburg and Schleswig-Holstein.

The problem is that the collateral on these loans is the ships themselves, and many of these ships are simply worthless given the glut of newer ships coming on to the market. So far, the shippers have been making their interest payments, which has helped the banks to avoid writing down the loans. But if the business dries up, the banks aren’t going to be happy with their security. It’s not a pretty picture for anybody concerned.

Peter Eavis notes something quite astonishing today:

The interest rate on [Goldman's] long-term borrowings was a minuscule 0.92% in the third quarter, down from 3.53% in the third quarter of 2008. This $203 billion of debt is Goldman’s largest single funding source, so as its cost plunges, its bottom line benefits…

Goldman has been helped by its use of interest-rate derivatives. When issuing long-term fixed-rate debt, Goldman has for years entered swaps that effectively convert nearly all of that debt to floating-rate. Thus, as interest rates plummeted, so did one of Goldman’s main expenses.

To put these numbers into perspective, a savings of 2.43 percentage points in one quarter amounts to $1.2 billion in saved interest costs on $203 billion. That’s over 40% of its third-quarter earnings.

Even so, Goldman’s hedging gains by converting fixed-rate into floating-rate debt pale in relation to $3.6 billion that Wells Fargo made on much the same trade, hedging its mortgage-servicing rights. Clearly much if not most of the US banking sector made enormous profits in Q3 on interest-rate swaps — profits which are the very definition of unsustainable.

And there’s another question, too: if the likes of Wells Fargo and Goldman Sachs are making billions on these swaps, who’s on the other side of the trade? Who lost billions of dollars by swapping floating into fixed? Call it the Summers trade, after Larry’s disastrous foray into the rates market when he was at Harvard. It didn’t work then, and it clearly isn’t working now, either.

It seems so obvious: of course John Bird and John Fortune should simply appear directly on FT.com. Go watch their latest George Parr interview, it’s fantastic:

GP: You can’t have it both ways. Everybody says that banks have got to be boring. Well, you’ve got to have an incentive to be boring.

There’s also a wonderful explanation of how securitzation works, at about 5:30.

GP: We thought we’d found a way where even if house prices didn’t go on rising forever, we wouldn’t have to worry about it.

Q: This is securitization.

GP: Securitization. You see, the problem about lending money who don’t have a glimmer of a chance of paying it back is that there’s a risk.

Q: That they won’t be able to pay it back?

GP: That’s not a risk, that’s a cast-iron certainty. No, no, the risk is that in some very complicated way the bank will lose money. Now what happens with securitization? You see before securitization, we could see the risk. It was there. We had it. And then, after securitization, what that did was, whooooo. The risk was sort of out there. Somewhere. Nobody knew. Then we looked back, and my god, it was still there after all!

Clever, that.

Michael Osinski has an interesting article on nymag.com about how he, a CMO-structurer-turned-oyster-farmer, is playing in the riskier end of the distressed-debt market.

I have no illusions about the risk of what I’m doing. Buying mortgage-backed bonds today is putting your finger to the wind in a storm, like you’re standing on a seawall facing a nor’easter. You know the second wave of defaults is coming. It’s forming out past Montauk, swelling in Gardiners Bay, about to smash into your seawall. Will it knock you down, rip your boat from its cleats, and scatter your oyster cages all along the rock pile?…

I buy my bonds through a former colleague named T…

You have to treat every bond like a time bomb, carefully assessing how much time you’ve got before it blows up in your face.

T. is selling me CMO bonds. I’ve bought seven of them in the last three months.

It’s a good, well-balanced piece, which shows how a sophisticated financial market professional is taking very careful and calculated risks with money he can afford to lose. He also knows, of course, that if he does end up losing that money, he has no one but himself to blame.

And then, at the end, it goes horribly, horribly wrong:

So how can you consider joining Michael Osinski and invest in toxic assets?

No!!!

The answer to that question is Do Not consider joining Michael Osinski. Do Not invest in toxic assets. And, whatever you do, Do Not start buying shares in things like BKT and HSM and TSI and FMY and HTR — ticker symbols all helpfully provided by nymag.com — especially if you think that in doing so you’re somehow replicating what Osinski is doing. You’re not.

Osinski is buying a very small number of very carefully-vetted bonds. This is the classic “PA” trade, where financial market professionals buy obscure instruments for their personal account in sizes which simply don’t scale up to the sort of money thrown around by institutional investors. Osinski’s bought seven bonds in three months, and I’m sure he went over each and every one in great detail with his friend T. That’s small-scale, highly-informed investing — the exact opposite of throwing your money at the Helios Total Return fund and hoping for the best.

Yes, the website does urge its readers to “be especially careful here”. But that doesn’t excuse spending 600 words on what you should do if, in a moment of recklessness, you decide that you want to ape the investing strategy of an oyster farmer who has just written a feature article for nymag.com, and who knows much more about what he’s doing than you ever will.