Opinion

Felix Salmon

When information systems fail

Felix Salmon
Oct 24, 2013 19:37 UTC

I’m reading Megan McArdle’s new book in galleys right now; its title is “The Up Side of Down: Why Failing Well Is the Key to Success”. Given the subject matter, McArdle spends just as much time discussing bad failures as she does discussing good ones — not the things which turned out in the end to be “the best thing that ever happened to me”, but rather the truly catastrophic things which result in wholesale destruction of wealth, health, or people’s lives.

Given the way in which the world is becoming increasingly dominated by complex technological systems, a lot of these failures are going to be technological in nature. Recent publicity, of course, has focused on healthcare.gov — a highly complex website devoted to solving the enormous problem of how millions of Americans will be able to access affordable medical care. And the general tone of the criticism, which is coming from all sides, is that if only the government had ______, then all of these problems, or at least most of them, could have been avoided.

That kind of criticism is always easy in hindsight, which doesn’t make it wrong. Virtually all problems are foreseen by someone, or should have been. But in no organization are all foreseen problems addressed promptly and directly. If they were, then nothing would ever happen. Which means that the real problem is often understood to be a managerial one: the lines of communication weren’t clear enough, the managers didn’t have their priorities right, how on earth could they have been so stupid as to _______.

David Wilson has found a wonderful example in the SEC’s censure of Knight Capital. Knight blew up as a result of badly-designed computer systems, and the cascade of mistakes in this case was particularly egregious: it kept important deprecated code on its active servers, it didn’t double-check to ensure that new code was installed correctly, it had no real procedures to ensure that mistakes like this couldn’t happen, it had no ability to work out why something called the 33 Account was filling up with billions of dollars in random stocks, despite the fact that the account in question had a $2 million gross position limit, it seemingly had no controls in place to stop its computers from doing massive naked shorting in the market, and so on and so forth.

In the end, over the course of a 45-minute period, Knight bought $3.5 billion of 80 stocks, sold $3.15 billion of another 74 stocks, and ended up losing a total of $460 million. Markets were definitely disrupted:

As to 37 of those stocks, the price moved by greater than ten percent, and Knight’s executions constituted more than 50 percent of the trading volume. These share price movements affected other market participants, with some participants receiving less favorable prices than they would have in the absence of these executions and others receiving more favorable prices.

Given the size of Knight’s losses, the only silver lining here is that Knight itself was the main actor receiving less favorable prices, while the rest of the market, in aggregate, ended up making more money that day than it otherwise would have done. But the SEC is right to fine Knight all the same, just as it was right to fine JP Morgan for its London Whale losses: legitimate trading losses are fine, but major risk-management failures are not allowed, and need to be punished by more than just trading losses.

Or, for a smaller-scale example, look at Dan Tynan’s misadventures with Box. Again, there was a series of management and permissioning failures, which ultimately resulted in Tynan’s entire account being vaporized, along with all its content. As he explains:

- Box handed control over my account to someone who was a complete stranger to me;

- They did it because of a one-time association with someone else, who happened to have access to some of my folders;

- They failed to notify me or any of my other collaborators that they were giving control of my account to someone else;

- They failed to confirm deletion of the account with the person who created it (i.e., me); and

- Box.com support was helpless to do anything about it or give me any information. Had I not pulled the journalist card, I’d still be scratching my head over what had happened.

That’s a lot of mistakes; nearly as many as can be seen in the Knight Capital case. But when you see a list this long, the first thing you should think about is Swiss cheese. Specifically, you should think about the Swiss cheese model of failure prevention, as posited by James Reason, of the University of Manchester:

In the Swiss Cheese model, an organization’s defenses against failure are modeled as a series of barriers, represented as slices of cheese. The holes in the slices represent weaknesses in individual parts of the system and are continually varying in size and position across the slices. The system produces failures when a hole in each slice momentarily aligns, permitting (in Reason’s words) “a trajectory of accident opportunity”, so that a hazard passes through holes in all of the slices, leading to a failure.

In other words, we should maybe be a little bit reassured that so many things needed to go wrong in order to produce a fail. The Swiss cheese model isn’t foolproof: sometimes those holes will indeed align. But a long list of failures like this is evidence of a reasonably thick stack of cheese slices. And in general, the thicker the stack, the less likely failure is going to be.

That said, there’s an important countervailing force, which mitigates in favor of more frequent failure, and which is getting steadily larger and scarier — and that’s the sheer complexity of all kinds of information systems. I mentioned this when Knight blew up, quoting Dave Cliff and Linda Northrop:

The concerns expressed here about modern computer-based trading in the global financial markets are really just a detailed instance of a more general story: it seems likely, or at least plausible, that major advanced economies are becoming increasingly reliant on large-scale complex IT systems (LSCITS): the complexity of these LSCITS is increasing rapidly; their socio-economic criticality is also increasing rapidly; our ability to manage them, and to predict their failures before it is too late, may not be keeping up. That is, we may be becoming critically dependent on LSCITS that we simply do not understand and hence are simply not capable of managing.

Under this view, it’s important to try to prevent failures by adding extra layers of Swiss cheese, and by assiduously trying to minimize the size of the holes in any given layer. But as IT systems grow in size and complexity, they will fail in increasingly unpredictable and catastrophic ways. No amount of post-mortem analysis, from Congress or the SEC or anybody else, will have any real ability to stop those catastrophic failures from happening. What’s more, it’s futile to expect that we can somehow design these systems to “fail well” and thereby lessen the chances of even worse failures in the future.

COMMENT

Please don’t refer to Reason’s swiss cheese model, it’s inadequate for explanation and prevention of these sorts of events, and has unfortunately been through a confusing history in the domains in which Reason originally spoke about (aviation, patient safety, power plants, etc.)

As to how indignant we can feel about Knight Capital’s shortcomings, we cannot take the SEC report as a postmortem document or accident investigation. I’ve written a good amount about that here:

http://www.kitchensoap.com/2013/10/29/co unterfactuals-knight-capital/

Posted by JohnAllspaw | Report as abusive

Bond-fund charts of the day, rising-rates edition

Felix Salmon
Oct 22, 2013 21:31 UTC

I’ve been a bit obsessed with trying to get a feel for exactly how much money bond funds might go down if and when interest rates start to rise. And now, thanks to the wonderful Jake Levy at BuzzFeed, I can show you, in animated, rubbable-GIF form!

Jake put together two GIFs for me. Both show what happens to a $1,000 bond fund over time: the first one shows the value of the fund at various different durations, and assumes that rates are rising at a modest 0.5% per year; the second one shows the effect of the speed with which rates rise, assuming a constant duration equal to that of the Barclays US Aggregate. If you view these charts at BuzzFeed, on a touch device, then you can click the little hand in the top right corner, drag your finger across them, back and forth, and see how things change.

anigif_enhanced-buzz-11920-1382467024-46.gif

These charts ultimately come out of a conversation I had with Emanuel Derman, and this clever tool from skewtosis. They’re also purely about interest-rate risk, rather than credit risk: the duration points and initial yields for the first chart correspond to the figures for the 1-year, 2-year, 3-year, 5-year, 7-year, and 10-year Treasury bonds.

As for the lesson to be drawn from the charts, one interpretation is that the big risk to bond funds isn’t rising rates so much as it’s rapidly rising rates. Sure, if rates rise slowly and your fund has substantial duration, then you could lose a bit of money. But if rates rise quickly, you could lose a lot of money. In the BuzzFeed version of these charts, which you can see here, I say that in a rising interest rate environment, it’s possible that bonds could actually be more risky than stocks. But I’m not sure what the implications are for asset allocation. Simon Lack, for one, would say that now’s the time to pretty much get out of bonds entirely, given their large downside and small upside. But I remember that Larry Summers managed to lose a billion dollars using the argument that “rates can’t fall any further”.

So maybe the real lesson here is simply that there just isn’t such a thing as a safe investment. Not even if it’s a Treasury bond.

COMMENT

Hey Felix. You stumbled on something your friendly neighborhood quantitative analyst has known for some time. Often the best scenario for financial intermediaries is the slow rise. It allows the bank, insurer, or S&L to build income while not getting smacked with large unrealized capital losses.

Because so many intermediaries would benefit from it, is part of the reason why it almost never happens. Rates moving in anticipation of tightening Fed policy is almost never gradual.

Posted by DavidMerkel | Report as abusive

Making sense of the JP Morgan settlement

Felix Salmon
Oct 22, 2013 15:14 UTC

Are you worried that JP Morgan is being robbed of $13 billion that rightfully belongs to shareholders? Richard Parsons (not the former Citigroup chairman, but rather the former Bank of America executive vice president) is shocked by the size of the JP Morgan settlement, trotting out a line of criticism which is pretty standard in Wall Street circles:

If it is true that J.P. Morgan Chase must pay penalties for mistakes made by Bear Stearns—a firm that Washington encouraged them to take over—then it is likely federal policy makers have actually increased systemic risk to the financial system. In a country that has seen 3,000 banks fail over the past 30 years and more than 12,000 over the past century, it is not difficult to imagine future bank failures…

Little thought seems to have been given to the pursuit of J.P. Morgan Chase over Bear Stearns. Once the government proves itself to be an unreliable “partner” in resolving failed institutions, it will find fewer banks willing to step in next time there is systemic risk to the banking system.

This is doubly false, and no one has done a better job of demonstrating its falseness than Peter Eavis. Back in September, Eavis explained, patiently, that JP Morgan bought Bear Stearns and Washington Mutual with its eyes open. (This isn’t hard to show, when Jamie Dimon was saying, at the time, things like “There are always uncertainties in deals; our eyes are not closed on this one.”) Besides, JP Morgan has made billions of dollars in profit on these deals, even after paying this settlement.

If you have any doubt about this, just look at the accounting. WaMu had shareholders’ equity of some $40 billion, before it was bought, which JP Morgan paid $1.9 billion for. JPM valued that equity at $3.9 billion, so it booked a $2 billion gain the minute that the acquisition closed; it then said that WaMu would contribute about $2.5 billion per year in extra profits going forwards.

The point here is that JPM fully expected that legacy WaMu assets would generate some $36.1 billion in losses. Now that those losses are starting to appear, all that we’re seeing is the arrival of something which was expected and priced in all along.

In reality, Washington Mutual did better than JPM expected: the bank is going to take a $750 million gain this quarter to reflect the outperformance of WaMu mortgages. (I’ll tender a guess, here: underwater mortgages are impossible to refinance, and as a result a huge proportion of JP Morgan’s underwater borrowers are paying well above-market interest rates.)

As a result, there’s no reason whatsoever for JPM to regret playing nice with the government in 2008 by buying Bear Stearns and WaMu. As the WSJ unambiguously reports (emphasis mine):

J.P. Morgan Chase & Co. is willing to pay a steep price to settle with the Justice Department over soured mortgage securities, but it is getting one thing it wanted: It won’t have to pay heavy penalties for the sins of two companies it bought during the financial crisis.

Under the terms of a tentative $13 billion deal that could be finalized in a matter of days, J.P. Morgan will pay roughly $2 billion in penalties that apply to its own conduct during the years before the financial crisis, and not any for problems it inherited from Bear Stearns Cos. or Washington Mutual Inc.

As Eavis explains today, the settlement breaks down into three parts. $6 billion goes to compensate investors for losses on mortgage securities; $4 billion is relief for homeowners; and the remaining $3 billion in fines is specifically targeted only at actions which took place directly under Dimon’s watch.

Despite the concerns that JPMorgan was being unfairly taken to task for the practices of Bear Stearns and Washington Mutual, investigations into the two firms are not expected to lead to any fines. Justice Department lawyers, one person said, decided against allocating fines to those firms because doing so might appear punitive. The government encouraged and helped arrange the two takeovers.

In other words, Parsons’ premise is exactly wrong: JPM is not paying penalties for mistakes made by Bear Stearns. All that it’s doing is making good on obligations of WaMu and Bear related to securities they sold. And it’s inherent in buying a bank that you become responsible for its liabilities as well as its assets.

There is one unexpected wrinkle to this settlement, however. As Matthew Klein point out, some $4 billion of JP Morgan’s non-fine money will go to the taxpayer all the same, in the form of the FHFA, thanks in large part to the dogged efforts of FHFA director Ed DeMarco. DeMarco has been micromanaging Fannie Mae and Freddie Mac for the past four years, which means that he — rather than Fannie and Freddie themselves — has taken the lead in terms of chasing down money the two agencies are owed by the banks from whom they bought mortgage securities.

DeMarco sits in a kind of weird regulatory limbo: technically he only regulates Fannie and Freddie, but because he’s a fully-empowered government regulator, that gives his lawsuits especial force. And so when he sues JP Morgan (and Citi, and Wells Fargo, and other mortgage-bond merchants), the suits fall somewhere in the middle between aggressive regulatory action and a simple civil claim brought by formerly private companies which suffered losses due to miss-sold securities. Most importantly, because DeMarco is a regulator, other regulators, including most importantly the Justice Department, can join in — and, ultimately, settle the whole deal for a huge headline sum.

The best way of looking at this JPM settlement, then, is not as a massive $13 billion fine for wrongdoing. Rather, you should think of it as an upsized out-of-court settlement between JP Morgan and the various private companies which bought mortgage bonds from JPM, WaMu, and Bear. Those companies were mostly Fannie and Freddie, which means that they’re now owned by the government, and so of course lots of other government baggage is being brought in at the same time. But what we’re not seeing is overreach by the SEC, by the Justice Department, by Treasury, or by any other government agency. And we’re certainly not seeing JPM being punished for takeovers which the government asked it to do. We’re just seeing two enormous and bureaucratic systems — the federal government, and JP Morgan Chase — doing their best to disentangle the various obligations that the latter has to the former. It’s opaque, and not particularly edifying. But it’s probably good, on net, for both parties.

COMMENT

Good insight. I keep seeing articles stating that shareholders will receive compensation ($6 billion in this article) early in 2014 but I’ve not been able to find any documentation regarding if the payout is tied to a date of ownership, the amount per share and when shareholders should expect payment. I was glad to see WaMu emerge as WMIH (which is showing great potential) but the value has in no way returned my investment. I’d appreciate any insight on shareholder compensation.

Posted by sap13 | Report as abusive

The IMF revisits sovereign bankruptcy

Felix Salmon
Oct 21, 2013 16:38 UTC

Last weekend, at the IMF annual meetings, I moderated an official panel with the snooze-worthy title “Sovereign Debt Restructuring: Lessons from Recent Experience”. But the room was packed, and attention was rapt: everybody wanted to know what the panelists in general, and one in particular, thought about the subject at hand. All eyes were on first deputy managing director David Lipton, who kicked off proceedings with a dry but important speech in which he praised a recent Brookings report as “excellent”.

Lipton’s speech came in the wake of a 49-page paper the IMF released in May, which tried to lay out the issues as seen from Fund headquarters. The paper raised quite a few eyebrows, since it marked the first time in a decade that the IMF has talked in public about changing the international financial architecture around debt restructuring. Its last attempt to tackle the subject, known as the Sovereign Debt Restructuring Mechanism, or SDRM, died ignominiously, bereft of any US support.

What do I think about Lipton’s idea? If you scroll down to the end of this rather long and dense post, you’ll find out. It’s OK, there won’t be a quiz, and you don’t need a detailed understanding of everything I’m going to cover in order to understand my conclusions. But for the suprisingly large number of sovereign debt nerds out there, I’m first going to lay out the issues, as they were presented during the IMF meetings.

Lipton, in his speech, said that he was worried that “official resources, including from the Fund, would be used to pay out other creditors”. He also said that “in cases where the need for debt reduction may be unclear at the outset, in our view the key is to keep creditors on board while the debtor’s adjustment program is given a chance to work”.

This idea is very close to the “standstill” that was originally proposed as part of the SDRM; another name for it is “default”. And as veteran sovereign debt advisor Rafael Molina patiently explained later on in the panel, sovereign debt managers will, as a rule, do anything to avoid defaulting on their debt. As a result, tensions are naturally very high whenever this idea is brought up, despite the upbeat spin that the IMF puts on it in its paper:

The primary objective of creditor bail-in would be designed to ensure that creditors would not exit during the period while the Fund is providing financial assistance. This would also give more time for the Fund to determine whether the problem is one of liquidity or solvency. Accordingly, the measures would typically involve a rescheduling of debt, rather than the type of debt stock reduction that is normally required in circumstances where the debt is judged to be unsustainable. Providing the member with a more comfortable debt profile would also have the additional benefit of enhancing market confidence in the feasibility of the member’s adjustment efforts, thereby reducing the risk that the debt will, in fact, become unsustainable.

Translating into English, the IMF here is essentially saying this: “Sometimes we don’t know whether a country’s debt is too high. We need time to work that out. But if we’re lending, during that period, then while we’re deciding whether or not the country’s debt is sustainable, we’re going to force it to default on its private debt.”

There are two big worries at the IMF, according to Lipton. The first is that the IMF sometimes ends up lending money to sovereigns too late, after the country in question has already racked up an unsustainable quantity of debt. The second is that when the IMF does lend money to a troubled sovereign, that money just turns around and leaves the country entirely, in the form of coupon payments to foreign bondholders. In other words, the IMF doesn’t want to be the last chump lending, even as everybody else is using an IMF program as a path for smoothing their exit out of the country.

Hence the IMF’s latest idea, which is not (yet) a fully-fledged proposal, but which is intended to become one at some point. Basically, if you’re a country with a high and possibly unsustainable debt load, then new IMF loans are going to come with the mother of all strings attached: you’re going to have to stop paying back your existing private creditors in full and on time. Instead, you’re going to have to restructure those loans, somehow — term them out, force them to be rolled over — and in doing so you’re going to see all of the ratings agencies, and all of your CDS contracts, unambiguously declare that you have defaulted on your debts.

In the private sector, such financing is extremely rare: you don’t often see lenders to a company insisting that before they lend, the borrower has to stop paying back its current debts as they come due. There’s really only one situation where that ever happens, which is the case of debtor-in-possession financing after a company files for bankruptcy. So despite the fact that the IMF is adamant that it is not attempting — second time lucky — to create a sovereign bankruptcy regime, it does look as though the Fund is steering in that general direction.

Indeed, it looks like the Fund is aiming for a kind of muddled middle — one which is the worst of both possible worlds. On the one hand, it’s going to force countries to default on their debts; on the other hand, after coming out of default, the countries in question will still have debts which are far too high. The good thing about bankruptcy proceedings is that companies emerge from them in viable form, even if doing so means that creditors are forced to take substantial losses. But if all the IMF wants is “more time for the Fund to determine whether the problem is one of liquidity or solvency” — and if it then makes the determination that the country is actually insolvent after all — then the mild restructuring will have to be followed with a much harsher one. And if defaulting once is bad, defaulting twice in short succession is much, much worse.

The official sector understands this fact about markets, although it has never much liked it. Official-sector creditors, including the IMF and its shareholders, never mark to market: when they make loans, they always keep those loans on their book at par, until such a day as the loans are officially written off. The result is the classic series of Paris Club restructurings, where loans get rescheduled, coupons get reduced, and the present value of the debt continually declines — but not where it matters, on the books of the creditors. If you’re a sovereign creditor, rescheduling debts costs you almost nothing, and so it is indeed a great way of buying time for the debtor.

But the Paris Club, just like the IMF, doesn’t like the idea that its generosity will be taken to the bank by private-sector creditors. As a result, it insists on something called “comparability of treatment”: if a country is getting a good deal from the Paris Club, then it needs to negotiate something similar with its private-sector creditors at the same time. Which might be possible when the private-sector creditors are banks, which can sit down across a negotiating table and hammer something out — especially if the banks in question are able to continue to hold the loans on their books at par, on the grounds that they’re being held to maturity.

When the private-sector creditors are bondholders, however, everything changes. The cost of restructuring bonds — a very public default — is much higher than the cost of restructuring loans. And so there’s a constant tension between the official sector and the private sector when it comes to restructurings. The official sector likes to drag things out, in a series of deals; the private sector much prefers to do a single big deal — what’s known in the trade as “one and done”.

In other words, the noises coming out of the IMF aren’t particularly new: they’re pretty standard official-sector whines. What’s new is that it’s the IMF making them, after a decade of studious silence on the subject.

The Fund is treading much more cautiously this time around than it did ten years ago. It’s listening to just about everybody with an interest in the subject, including the wide range of views represented by its own board. (While creditor countries can see where the Fund is coming from, debtor countries are generally pretty solidly opposed, since they fear that any moves in this direction will only serve to drive up their borrowing costs.) Before my panel, for instance, the Fund hosted a discussion between 20-odd experts from the private sector and academia, with a wide range of views.

I was impressed by the certainty with which the various participants expressed their views, because I have no particular dog in this fight, and generally just find myself agreeing with whoever the last person to speak was. Virtually everybody there had an extremely strong case, despite the fact that many of them were deeply opposed to each other. I’ll try to give a flavor of the full range of views here, since it was hard to do that in the public panel. Obviously, many of these views are mutually inconsistent, but they’re all held by some important constituency somewhere — which should give you an idea of how hard the IMF’s job is, if it wants to achieve any kind of consensus on this issue.

The best place to start, though, if only because the views have names attached to them, is the Brookings report. The lead authors include Lee Buchheit, the dean of sovereign debt restructuring, and lawyer who has represented debtor nations around the world. Also on the lead-author list is Jeromin Zettelmeyer of the EBRD, although he’s at pains to point out that his involvement in the report was personal, and that the report does not necessarily reflect the views of the EBRD. More interestingly still, if you look down the list of other committee members involved in putting this report together, you’ll find the name of the biggest buy-sider of them all, Mohamed El-Erian. From what I can glean, he was not an active participant in the process. But the fact that his name is here at all is noteworthy, since there’s a lot in the report to antagonize the buy side in general.

The report unapologetically uses the b-word in its title, “Revisiting Sovereign Bankruptcy”, and is a pretty radical document, if by “radical” you mean the opposite of “market-friendly”. It says that there’s now “a much stronger case for an orderly sovereign bankruptcy regime today than ten years ago”, and lays out what is referred to by critics as the “Greece and Griesa” argument. Basically, the lesson of Greece — and of the euro crisis more generally — is that sovereign overindebtedness is a much bigger problem than anybody thought it was in 2003. As such, if some kind of sovereign bankruptcy regime helped to constrain the amount that countries could borrow on the private market, well, that might be a good thing, rather than — as people thought in 2003 — a self-evidently bad thing. On top of that, Thomas Griesa, a federal judge in New York, has created a huge precedent with his rulings about the way that the pari passu clause can and should be interpreted in bond documentation. In the wake of those rulings, bondholders are more likely to hold out, rather than tendering their bonds into an exchange. As a result, bond exchanges are going to be more and more difficult to execute successfully, and therefore there needs to be some kind of alternative way to restructure a nation’s bonded debt.

The Brookings paper essentially comes up with two separate sovereign bankruptcy regimes: one for the Eurozone, and one for everybody else. This makes sense to me: a one-size-fits-all solution is never going to be optimal with respect to addressing the very specific and idiosyncratic nature of European sovereign debt problems. In both cases, however, the Brookings paper proposes major new legislative changes: an amendment of the IMF articles, as well as an amendment of the ESM treaty in Europe. And in both cases the amended treaties would set an ex ante level for debt-to-GDP ratios, over which no new official-sector money would be lent without a debt restructuring taking place.

There are obvious problems with using a blunt instrument like the debt-to-GDP ratio to determine whether a debt restructuring is necessary. In fact, the Brookings paper goes in the exact opposite direction to the IMF, which is trying to make its debt sustainability analyses increasingly sophisticated. (For instance, if you look at the debt sustainability analysis on pages 43-45 of the Italy Article IV report, you’ll see a range of scenarios, with associated probabilities, rather than just a simple projection.) Obviously, the simple debt-to-GDP ratio excludes a huge number of very important factors: Japan, with its stratospheric debt-to-GDP ratio, is still vastly more creditworthy than Argentina, whose debt-to-GDP ratio is very low. And more generally, flows tend to matter more than stocks: ceteris paribus, the market will always prefer a country with a 100% debt-to-GDP ratio which is in primary balance, on the one hand, to a country with a 50% debt-to-GDP ratio and a primary deficit of 15% of GDP, on the other.

The Brookings paper argues that trying to put together a more complex threshhold, or even coming up with a bespoke number for every country on a case-by-case basis, is an approach which is certain to be gamed, and ultimately to fail. The point of this proposal is to tie the official sector’s hands — since one of the articles of faith underlying both the current IMF project and the Brookings paper is that the official sector has been too weak when it comes to saying no to countries needing funds. The official sector faces “a simple choice,” says the Brookings paper: “to adopt simple ex-ante rules that constrain discretion when structuring rescues, or to adopt no rules. Given the biases that currently exist against any form of debt restructuring, pure discretion would lead to bigger errors than simple rules.”

This is a highly contentious statement: Much of the buy side, for one, is genuinely convinced that the system isn’t broken, and shouldn’t be fixed. Putting in place a system where official-sector funding requires debt default, they say, plausibly enough, will only make matters worse: any time that a country even thinks about approaching the IMF or the ESM for help, markets will plunge, and bondholders will rush to be the first ones out the door.

Under this view, there are many countries — Brazil in 2002, Portugal and Italy more recently — which are clear success stories thanks to official-sector support, and which would have turned into debt-default failures had this kind of a scheme been in place. Official-sector types, on the other hand, are not entirely convinced that Portugal and Italy really are successes, and they reckon that even Brazil got very lucky with booming commodity prices and extraordinarily low global interest rates.

On the other hand, default isn’t what it used to be. Bond defaults used to be rare, just because sovereign bonds were rare: until the Brady plan in the 1990s, most sovereigns with any propensity to default would simply borrow money from banks rather than attempt to tap the bond market. Once bonds replaced loans, then bond defaults started. At first, they were shocking, but each new default makes them seem less so: statistically speaking, if you have a lot of sovereigns with a lot of debt, then some of them are going to default.

As a result, there’s a significant constituency — including quite a lot of academics looking at things like market access and bond spreads — that has a rather more nuanced view of default than the black-and-white idea that it’s always and everywhere a really bad idea, to be avoided at all costs. Under this view, if you look at successful bond restructurings in the past, then countries do indeed get punished quite harshly in terms of market access and bond spreads if they impose harsh and punitive haircuts on their creditors. On the other hand, if the restructuring is market-friendly and is really more of a reprofiling than an outright haircut, then the country often suffers quite minimal adverse consequences.

Those that see default in shades of gray like to draw distinctions and invent new words: rather than “default”, they say, can’t we use the word “treatment” instead? And in any case, don’t most bondholders, in reality, tend to agree on what needs to be done? After all, the elegance of bond markets is that when a country gets into trouble, the original holders of the debt are likely to sell it at a loss to people who can make a profit, even if (especially if) the country goes through a successful restructuring. Argentina is a particularly contentious outlier: in pretty much every other restructuring, holdouts really haven’t been an issue. And even Argentina can be seen as a success story in one respect: because its default happened so slowly, and was telegraphed so clearly, it had very little in the way of spill-over effects. It’s the sudden defaults, like Russia’s, which are the most dangerous: a clearly-foretold default allows the bonds to be held in large part by speculative investors who might actually make money in the event of a restructuring. As a result, a mild default like the one proposed by the IMF could do wonders in terms of minimizing contagion risks.

This argument doesn’t persuade the more hard-minded market types, who say that if holdouts haven’t been an issue up until now, that proves that the current system is working. What’s more, if the official sector starts bigfooting into the markets and telling countries to default, then at that point you can be sure that holdouts will be an issue — especially since the hedge funds who buy sovereign debt at low prices are exactly the hedge funds which are most likely to hold out. The official sector always seems to want the private sector to take a very large haircut, and restructurings have been successful to date only because the debtor and the markets have had the ability to push back against the IMF. (See, for example, Uruguay.)

Some participants go even further, and say that the current system is already too biased against bondholders. Sure, they’ve done OK for themselves — so far — in Portugal and Italy. But look at cases like Greece, Argentina, and Russia: in those countries, bondholders had to take enormous haircuts, in part because there was so much official-sector financing which insisted on preferred-creditor status. If a country has to pay off its preferred creditors in full, then any given necessary debt reduction is going to fall all the more heavily on the private sector. And if the IMF is going to come up with some kind of system for imposing losses on the private sector, that’s a clear sign that the Fund thinks that the private sector’s losses right now are too small.

Lipton sounds at best overoptimistic and at worst downright disingenuous when he says that “providing the member with a more comfortable debt profile would also have the additional benefit of enhancing market confidence in the feasibility of the member’s adjustment efforts, thereby reducing the risk that the debt will, in fact, become unsustainable.” No bondholders are ever going to actively welcome an IMF program which includes a bond default, even if that default in practice doesn’t involve much in the way of present-value losses. Lipton seems to believe that such a program could cause bond yields to go down; that seems like wishful thinking to me.

So, where do I stand on all this? I’d make three main points.

Firstly, this whole thing looks to me a bit too much like a solution in search of a problem. Hard cases make bad law, and when your entire reason for taking action can be boiled down to Greece-and-Griesa, two cases which are highly unique and idiosyncratic, then you’re always going to run the risk of overreach. The big story in emerging markets over the past decade is that their local debt markets have become much deeper and more liquid, meaning that they’re increasingly capable of funding themselves domestically. And domestic debt is not an issue: any time a government wants to default on its domestic debt it can, or alternatively it can just print money to cover the obligations.

The main exception to this rule is the eurozone, where governments do not have control over their own currency. Which is another way of saying that at heart this is really a European problem, rather than a global one, and that it should be solved at a European level, rather than at the level of the IMF. What makes sense for Ireland is unlikely to make sense for Brazil.

What’s more, in Europe, even more than in the rest of the world, debt restructuring is a very bad way of saving money overall. Sure, you can impose losses on sovereign bondholders — but those sovereign bondholders are very likely to be domestic banks. Which means that for every euro you save in government debt, you’re going to end up spending roughly one euro in bank recapitalization.

So rather than concentrate on bond exchanges, I think the Fund — along with Europe’s technocrats — should think much more about alternative ways of retiring outstanding debt at below face value. Ecuador did this very effectively in its most recent default: it simply used cash to buy up its own debt at a deep discount. And if you look at the amount of money that the official sector ploughed into the Greek exchange, it wouldn’t have taken much more to simply buy up most of the outstanding private debt on the public markets, and get rid of it that way.

I do understand that Greece has worried the IMF — and that Griesa has worried them even more. But it’s crazy to let a single vulture fund — Elliott Associates — effectively set the agenda for the design of the entire international financial architecture. Ten years ago, Anne Krueger was prompted to propose SDRM by Elliott’s shenanigans in Peru; today, Lipton is similarly motivated by Elliott’s successes against Argentina. (Not that Elliott has actually gotten paid, yet.) But if the IMF ends up moving in the direction it’s thinking about, the result could end up being counterproductive for everybody. So let’s think seriously about Europe, first. Only then, and only if a European solution proves obviously successful, should we start considering extending something similar to the rest of the world.

COMMENT

.

It is far better then what is currently occurring

money going straight to the banks that took the risk
and profited from the risk in the first place

and then get paid back on the taxpayers dime.

.

Posted by Alexaisback | Report as abusive

The SEC’s weird case against Wing Chau

Felix Salmon
Oct 19, 2013 22:07 UTC

Merrill Lynch closed its Octans 1 CDO in September 2006. By April 2008, a year and a half later, the CDO had completely imploded, inflicting roughly $1.1 billion of losses on its outside investors. Now, five and a half years after that, the SEC has finally got around to launching a lawsuit against the CDO manager, Wing Chau.

If that name seems familiar to you, it’s probably because you read The Big Short, Michael Lewis’s account of the men who made a fortune shorting subprime. The biggest villain in that story was Chau, who went on to (unsuccessfully) sue Lewis and his publisher for defamation. Chau’s complaint was that as a result of the publication of Lewis’s book, his “ability to work in his chosen profession has been severely diminished”. Given that his chosen profession is to manage CDOs, one would think his ability to work there would be severely diminished whether the book had been published or not: there’s precious little demand for such services these days. But in any case, if he retained any kind of professional life at all, this SEC lawsuit is likely to kill it stone dead.

That said, the SEC’s suit is a very weird thing. For one thing, the Octans 1 CDO was constructed and marketed not by Wing Chau but rather by Merrill Lynch. The SEC has been looking into Merrill’s CDO shenanigans since June 2011, but — for the time being, at least — Merrill has escaped any kind of CDO-related litigation, even as Citigroup, JP Morgan, Wells Fargo, UBS, and Goldman Sachs (in the notorious Abacus deal) have all paid substantial fines for such things.

And it’s Merrill’s marketing materials, much more than any action by Wing Chau, which are at the heart of the SEC’s case. The problem with Octans 1 is that a hedge fund called Magnetar had some control over its contents, and Magnetar’s role in helping to shape the contents of the CDO was not disclosed to investors. The SEC’s case rests wholly on the fact that the Octans 1 pitchbook and offering circular made no mention of “Magnetar’s rights in and influence over the collateral selection process”. This may or may not have been a felonious omission, but either way it’s hard to see how Wing Chau is really at fault.

The SEC should know this better than anybody. After all, they’ve been here before. In June 2011, it charged Edward Steffelin, another CDO manager, with basically exactly the same thing as it’s accusing Wing Chau of doing now. It makes sense that the SEC charged Steffelin before it charged Chau, because the case against Steffelin alleged all manner of juicy back-channel dealings between Steffelin and Magnetar:

In a complaint filed against Steffelin, who headed the team at GSC responsible for the Squared CDO, the SEC alleges that Steffelin allowed Magnetar to select and short portfolio assets. The complaint alleges that Steffelin drafted and approved marketing materials promoting GSC’s selection of the portfolio without disclosing Magnetar’s role in the selection process. In addition, unknown to investors, Steffelin was seeking employment with Magnetar while working on the transaction.

Those employment enquiries notwithstanding, however, the SEC’s case against Steffelin was ultimately pretty flimsy, and collapsed, ignominiously, in May 2012, with the SEC dropping all charges. James Stewart had an excellent column, a few months later, laying out the facts:

At first blush, Mr. Steffelin’s case may have looked like Goldman’s. The S.E.C. charged that Mr. Steffelin allowed a large investor in mortgage-backed securities, a hedge fund called Magnetar Capital, to help choose the assets in the C.D.O. that JPMorgan structured and marketed. The commission further contended that Magnetar was betting against some of those securities and that Mr. Steffelin should have disclosed this to investors, but did not.

Among the problems with this theory were Mr. Steffelin’s claim that Magnetar didn’t choose the assets that went into the deal, even if it was aware of some of them (JPMorgan made the final decision); that JPMorgan, not Mr. Steffelin, was responsible for the offering documents and that Mr. Steffelin accurately provided whatever information JPMorgan wanted; and that lawyers for GSC and JPMorgan scrutinized the offering materials and signed off on them, so Mr. Steffelin, who isn’t a lawyer, had every reason to believe they passed muster.

Replace “JP Morgan” here with “Merrill Lynch”, “Steffelin” with “Chau”, and “GSC” with “Harding”, and Stewart could have written exactly the same thing about the current case. Magnetar did not choose the assets in Octans 1: the deal was put together by Merrill Lynch so as to be acceptable both to Magnetar and to Chau. Chau was even more of an active participant in putting the CDO together than Magnetar was. The offering documents were Merrill’s, not Chau’s. And it’s a bit weird to prosecute Chau for failure to make certain disclosures, when firstly he’s not a lawyer, and secondly he wasn’t in charge of what was being disclosed in the first place.

So why is the SEC bringing this case against Chau, when its case against Steffelin collapsed, and the case against Merrill Lynch would appear to be much stronger? (JP Morgan didn’t even fight the Steffelin case: it settled, immediately, for $153.6 million.) Maybe they figure that Chau can’t afford to fight: Stewart reported that Steffelin’s legal fees ended up being more than $3 million, all of which was paid for by GSC’s insurer, AIG. Fresh off one legal defeat, it’s easy to see how Chau might not have a lot of appetite for another big fight.

Maybe it’s just that Chau is one of the few named villains of the financial crisis: if you’ve read one book on the subject, it’s probably Lewis’s, and Chau comes off very badly there. With the SEC looking for a slightly higher-profile individual scalp than Fabrice Tourre, they alighted on Chau. But the fact is that the SEC’s case is very weak, and this case looks not only tardy but also pretty desperate. If Chau has the financial and emotional wherewithal to fight it, I suspect he’ll win pretty easily.

Bad investment of the day, Fantex edition

Felix Salmon
Oct 18, 2013 13:43 UTC

Now that the ban on general solicitation is over, all manner of weird companies are emerging from the nether regions of the internet, trying to persuade people to part with their money in return for a nominal stake in some unlikely investment. One of the glossiest of these new companies is Fantex, which just filed a prospectus for its first athlete-IPO.

Fantex couldn’t have hoped for better press: the NYT covered the story in its Venture Capital section, under the headline “If You Like a Star Athlete, Now You Can Buy a Share”. ESPN, meanwhile, went with “Fantex to offer Arian Foster stock”, while USA Today opted for “Want to invest in NFL’s Arian Foster? Here’s a chance”. Which just says to me that none of the journalists actually read and understood Fantex’s S-1.

The idea here is not a new one; indeed, Michael Lewis wrote about it in depth as long ago as April 2007.

When financial historians look back and ask why it took Wall Street so long to create the first public stock market that trades in professional athletes, they will see ours as an age of creative ferment. They’ll see a new, extremely well-financed company in Silicon Valley that, for the moment, sells itself as a fantasy sports site but aims to become, as its co-founder Mike Kerns puts it, “the first real stock market in athletes.” And they’ll find, in the bowels of the U.S. Patent and Trademark Office, an application from a cryptic entity called A.S.A. Sports Exchange containing a description of a design for just such a market: The athlete would sell 20 percent of all future on-field or on-court earnings to a trust, which would, in turn, sell securities to the public.

Kerns’ cryptic entity ended up being called Protrade, and going exactly nowhere. But Fantex is basically exactly the same thing, just a little bit more complicated and less attractive to investors. With Protrade, you’d buy shares in a trust, which would own 20% of any athlete’s earnings. With Fantex, by contrast, you buy shares in Fantex — a highly risky startup company which is losing money and which has precious little income with which to cover its substantial expenses.

The vast majority of the shares in Fantex — 100 million, to be precise — are closely held by its founders and backers. But another 1 million are being sold to chumps at $10 apiece, to raise the $10 million that Fantex is going to pay Arian Foster, who currently plays football for the Houston Texans. The chumps are buying something called a “tracking stock”, the performance of which is supposed to mirror the economic fortunes of the 27-year-old athlete. And maybe it will. Or, maybe it won’t. The directors of Fantex are under no obligation to pass Foster’s earnings on to shareholders in the form of dividends — even assuming that the contract with Foster does indeed do what it’s meant to do, and result in Fantex receiving 20% of Foster’s earnings, more or less in perpetuity.

The press surrounding Fantex makes it seem as though the biggest risk here is that Foster ends up with a dud of a career — and that is indeed one of the many risks with this investment. But that’s also exactly what Fantex wants you to think: that your stock will go down if Foster does badly, and will go up if he does well.

In reality, however, there are even more non-Foster risks to this stock than there are Foster risks. Your stock, for instance, can only be traded on an exchange which is owned and operated by Fantex. The directors of Fantex can, at their sole discretion and at any time, convert all your Foster shares into common Fantex shares, at any ratio which they determine to be fair. Or, more realistically, they can just go bust: after all, as the prospectus notes, they have no experience in this business. And if they go bust, then the holders of the tracking stock will end up owning about 1% of a bankrupt company, no matter how successful Foster is. As the prospectus says:

While we intend for our Fantex Series Arian Foster to track the performance of the brand, we cannot provide any guarantee that the series will in fact track the performance of such brand. The board of directors has discretion to reattribute assets, liabilities, revenues, expenses and cash flows without the approval of shareholders of a particular tracking series, which discretion will be exercised in accordance with its fiduciary duties under Delaware law and only where its decisions are in the best interests of the company and the stockholders as a whole.

In other words, when the directors decide “to reattribute assets, liabilities, revenues, expenses and cash flows”, their duty is to Fantex, the holding company, and not to the chumps with the Foster shares, who between them account for less than 1% of Fantex’s equity. And in general, as the prospectus also says, “any of our tracking series will be subject to the risk associated with an investment in Fantex as a whole”.

This investment, then, is basically the worst of all possible worlds: if Foster fails, it fails, and if Fantex fails, it also fails. And even if they both do quite well, you’ll only be able to profit on your investment insofar as a completely separate business — the Fantex stock exchange — actually works.

Fantex isn’t looking to raise a huge amount of money here: $10 million should be achievable, given the vast sums bet on fantasy leagues every season. You only need 5,000 chumps investing $2,000 each and you’re there. So Foster is likely to get his cash. But after that, I can’t see this thing going well. Football players are notoriously bad at organizing their finances; is Foster really likely to manage to timely file his mandated Quarterly Report, which “shall detail all Brand Income earned during such quarter, detail the calculation of the Brand Amount for such quarter with respect to such Brand Income, and provide such additional information and certifications required to be included in the Quarterly Report, including such matters as specified in Exhibit E”, within ten days of the end of every calendar quarter, for the rest of his career?

Some time quite soon, Foster is going to receive a $10 million check from Fantex; if he’s typical of most 27-year-old star football players, he’s likely to spend most if not all of that money pretty quickly. But for what will probably be the rest of his life, he’s going to be burdened by what is essentially a private 20% income tax, over and above everything he owes to the government, and to his creditors.

There might be people out there who like the idea of buying and selling stock in Arian Foster — speculating on the fortunes of someone else. But if they stop to think about what they’re doing, they’ll probably realize that it’s pretty distasteful. What they’re trading is the present value of Foster’s future earnings: they’re saying that in many years’ time, long after Foster has left the gridiron for good, they will be sitting there, with their hands out, every quarter, demanding from him 20% of everything he earns. Here’s how the Fantex website puts it:

IT DOESN’T HAVE TO END AT RETIREMENT.

This is a stock linked to the value and performance of an athlete’s brand, not the person. When the athlete retires, their brand may or may not continue to generate income into the future (e.g. endorsements, appearances, broadcasting, etc.). As long as the brand continues to generate income as defined in the brand contract, Fantex, Inc. is entitled to continue to receive payments pursuant to its brand agreement.

This kind of language is deliberately dehumanizing: the athlete is referred to not as a person but as a “brand”, throughout. And the racial overtones are unavoidable: Fantex’s About page features four grinning middle-aged white men, while the man they’re taking 20% of is young and black. This isn’t slavery, this isn’t ownership. But the rich white businessmen are buying something for their $10 million, while Foster is legally binding himself to writing substantial checks to those businessmen, and/or their successors, every three months, for what is quite likely to be the rest of his life.

Before you put any money into Fantex, then, ask yourself two questions. First, do you want to make a really stupid investment? And second, do you really want to buy shares in a company which treats young black men as property to be acquired and then privately taxed? Because that’s exactly what you’re going to be doing.

COMMENT

We are happy to answer any questions you may have, please call us between 9:30 AM ET and 8:30 PM ET @ 855.905.5050.

The Fantex Brokerage Services Team

Posted by Fantex | Report as abusive

Barack Obama vs zombies

Felix Salmon
Oct 16, 2013 15:50 UTC

There’s a strain of triumphalism coursing through the blogosphere today, on the grounds that the bonkers wing of the Republican party is going to have achieved exactly none of its own goals, while inflicting upon itself a massive black eye. The markets are feeling vindicated too: over the past week of DC craziness, the stock market has risen, pretty steadily, a total of about 2.5%. As a trading strategy, “tune out all news from inside the Beltway” seems to have worked very well — it’s a complete vindication of the Nassim Taleb idea that investors shouldn’t read the newspaper. On top of that, the potential debt default was by its nature almost impossible to trade: outside a few obscure instruments like US CDS, it’s very difficult to make money from a trade betting that tails are going to get fatter, for a short while.

But as a feeling of relief courses through Washington and the markets, let’s not get carried away. Yes, as Jonathan Chait says, it’s very good news that the House Republicans’ plan collapsed. But the can hasn’t been kicked very far down the road: we’re going to hit the debt ceiling again in just a few short months. And at that point, one of two things will happen. Either the Republicans, licking their self-inflicted wounds from the current fiasco, will quietly and efficiently pass a bill while getting nothing in return. Or, in the spirit of “if at first you don’t succeed”, they will try, try again.

Joe Weisenthal, like Chait, is hopefully eyeing the first possibility.

And Chait himself goes even further:

We can’t be certain Republicans will never hold the debt ceiling hostage again; but Obama has now held firm twice in a row, and if he hasn’t completely crushed the Republican expectation that they can extract a ransom, he has badly damaged it. Threatening to breach the debt ceiling and failing to win a prize is costly behavior for Congress — you anger business and lose face with your supporters when you capitulate. As soon as Republicans come to believe they can’t win, they’ll stop playing.

The problem is that, pace Weisenthal, you can’t just kill someone’s revolutionary nihilism. The Ted Cruz “filibuster” is a great example: it served no actual legislative purpose, and at the end of his idiotically long speech, Cruz ended up voting yes on the very bill he was trying to kill. That’s zombie politics, and the problem with zombies is that — being dead already — they’re incredibly hard to kill.

The point here is that the zombie army, a/k/a the Tea Party, is a movement, not a person — and it’s an aggressively anti-logical movement, at that. You can’t negotiate with a zombie — and neither can you wheel out some kind of clever syllogism which will convince a group of revolutionary nihilists that it’s a bad idea to get into a fight if you’re reasonably convinced that you’re going to lose it. Spoiler alert: it turns out that Ed Norton was beating up himself, all along. When you’re Really Angry, sometimes losing a big fight against The Man is exactly what you feel like doing.

This is why Michael Casey is right: the US should be downgraded. Zombies have taken over a large chunk of the Capitol, and there’s no particular reason to believe that they’re going away any time soon. We will have more sequesters, and more shutdowns, and more debt-ceiling fights, and eventually, in a statistical inevitability, we will fail to find some kind of way through the mess. Besides, as Casey says, even if we do, somehow, manage to muddle through, that doesn’t change the basic underlying fact: “triple-A credits do not behave like this.”

Remember that the sequester was initially put into place as a way to force the hand of any self-interested, logical group of politicians. They had to either come to an agreement — or face an outcome which was specifically designed to be as unpalatable to as many different interest groups as possible. And yet, despite the Sword of Damocles hanging over their heads, the politicians squabbled until it fell. The bigger sword, the debt ceiling, has not fallen yet — but I for one have no particular faith in the ability of Congress to always prevent it from doing so.

Yes, the President has won an important battle against the zombies. But while it’s possible to win a zombie battle, it’s never possible to win a zombie war. No matter how many individual zombies you dispatch, there will always be ten more where they came from. The Tea Party doesn’t take legislative defeat as a signal that it’s doing something wrong: it takes it as a signal that nothing has really changed in Washington and that they therefore need to redouble their nihilistic efforts. Take it from me: come February, or March, or whenever we end up having to have this idiotic debt-ceiling fight all over again, the Tea Party will still be there, and will still be as crazy as ever. A bruised zombie, ultimately, is just a scarier zombie.

Update: Many thanks to Dan Drezner, who has helpfully supplied the soundtrack to this post:

COMMENT

Career politicians, not zombies, have taken over all of our government and the news media. What’s your position on Gerrymandering, Felix?

Posted by JohnOfArc | Report as abusive

The default has already begun

Felix Salmon
Oct 14, 2013 22:23 UTC

The big question in Washington this week is whether, in the words of the NYT, we’re going to see “a legislative failure and an economic catastrophe that could ripple through financial markets, foreign capitals, corporate boardrooms, state budget offices and the bank accounts of everyday investors”. In this conception — and I have subscribed to it just as much as anybody else — the sequester is bad, the shutdown is worse, and the default associated with hitting the debt ceiling is so catastrophic as to be unthinkable.

This frame is a useful one, not least for the politicians in Washington, who seem to have become inured to the suffering caused by the shutdown, and downright blasé about the negative consequences of the sequester. Both of them could last more or less indefinitely were it not for the debt ceiling, which is helpfully providing a hard-and-fast deadline: Congress is going to have to come up with a deal before the ceiling is reached, because the alternative is, well, the zombie apocalypse.

There’s more than a little truth here: I’m a firm believer, for instance, that the president both can and should prioritize debt repayments in the event that the debt ceiling is reached. If we’re going to be so stupid as to hit the ceiling, then prioritizing debt service is the least-worst outcome. But at the same time, the situation is less binary than it looks, not least because the US government is already in default on its obligations.

The best way to look at this, I think, is that there’s a spectrum of default severities. At one end, you have the outright repudiation of sovereign debt, a la Ecuador in 2008; at the other end, you have the sequester, which involves telling a large number of government employees that the resources which were promised them will not, in fact, arrive. Both of them involve the government going back on its promises, but some promises are far more binding, and far more important, than others.

Right now, with the shutdown, we’ve already reached the point at which the government is breaking very important promises indeed: we promised to pay hundreds of thousands of government employees a certain amount on certain dates, in return for their honest work. We have broken that promise. Indeed, by Treasury’s own definition, it’s reasonable to say that we have already defaulted: surely, by any sensible conception, the salaries of government employees constitute “legal obligations of the US“.

Conversely, if you really do expect zombies to start roaming the streets the minute that the US misses a payment on its Treasury obligations, you’re likely to be disappointed. Yes, the stock market would fall. But the price of Treasury bonds would remain in the general vicinity of par, and it might even go up if Treasury announced that past-due interest would be paid on all debt at a statutory rate of 8% per annum. Even when it’s Treasury bonds themselves which are the instruments in default, Treasury bonds remain the world’s flight-to-quality trade, and the expected recovery on all defaulted Treasury obligations would be 100 cents on the dollar — or more.

The harm done to the global financial system by a Treasury debt default would not be caused by cash losses to bond investors. If you needed that interest payment, you could always just sell your Treasury bill instead, for an amount extremely close to the total principal and interest due. Rather, the harm done would be a function of the way in which the Treasury market is the risk-free vaseline which greases the entire financial system. If Treasury payments can’t be trusted entirely, then not only do all risk instruments need to be repriced, but so does the most basic counterparty risk of all. The US government, in one form or another, is a counterparty to every single financial player in the world. Its payments have to be certain, or else the whole house of cards risks collapsing — starting with the multi-trillion-dollar interest-rate derivatives market, and moving rapidly from there.

And here’s the problem: we’re already well past the point at which that certainty has been called into question. Fidelity, for instance, has no US debt coming due in October or early November, and neither does Reich & Tang:

While he doesn’t believe the U.S. will default, Tom Nelson, chief investment officer at Reich & Tang, which oversees $35 billion including $17 billion in money-market funds, said that the firm isn’t holding any U.S. securities that pay interest at the end of October through mid-November because if a default does take place, “we’d be criticized for stepping in front of that train.”

The vaseline, in other words, already has sand in it. The global faith in US institutions has already been undermined. The mechanism by which catastrophe would arise has already been set into motion. And as a result, economic growth in both the US and the rest of the world will be lower than it should be. Unemployment will be higher. Social unrest will be more destructive. These things aren’t as bad now as they would be if we actually got to a point of payment default. But even a payment default wouldn’t cause mass overnight failures: the catastrophe would be slower and nastier than that, less visible, less spectacular. We’re not talking the final scene of Fight Club, we’re talking more about another global credit crisis — where “credit” means “trust”, and “trust” means “trust in the US government as the one institution which cannot fail”.

While debt default is undoubtedly the worst of all possible worlds, then, the bonkers level of Washington dysfunction on display right now is nearly as bad. Every day that goes past is a day where trust and faith in the US government is evaporating — and once it has evaporated, it will never return. The Republicans in the House have already managed to inflict significant, lasting damage to the US and the global economy — even if they were to pass a completely clean bill tomorrow morning, which they won’t. The default has already started, and is already causing real harm. The only question is how much worse it’s going to get.

COMMENT

The posturing of the egocentric leadership “on the Hill” is despicable. They make too much money to do too little work and are only interested in promoting their private agendas (Reelection, Power, Money, Reelection,….) As an active constituency (NOT Tea Party), we MUST take back our government by voting out all incumbents and create “Term limits by the People, for the People and of the People” to remove the decaying odor of those gluttonous relics who have been feeding at the trough for far too long. We need people to lead our great nation out of this quagmire through compromise and respectful dialog with a genuine desire to serve the interests of the American People First & Foremost through reinstatement of the core values of The Declaration of Independence and The Constitution of the United States of America (51% Rules)!

Posted by BigKidBrother | Report as abusive

Is JP Morgan being unfairly singled out?

Felix Salmon
Oct 11, 2013 20:41 UTC

JP Morgan is the first big bank to suffer a quarterly loss on account of multi-billion-dollar legal bills. It is also the most profitable bank in America (or was, up until this morning). Which means there are three possibilities here:

  1. The profits and the fines share a common cause: the internal behavior which produces massive profits also — eventually — has a tendency to produce massive fines.
  2. The profits and the fines are unrelated: it’s just unfortunate bad luck that such a well-run, profitable bank should come unstuck in this manner.
  3. The profits in some way caused the fines: regulators feel comfortable going after JP Morgan precisely because it has a fortress balance sheet and can easily pay the fines.

All three of these have a kernel of truth to them, I think. If you look at misbehavior like the Libor scandal or the London Whale debacle, the misconduct in question was clearly driven by traders looking to make as much money as possible. But all banks have traders looking to make as much money as possible, and most of the world’s biggest banks have been sucked in to the Libor scandal, in one way or another. And if you look at classic trading blowups, they’re pretty uncorrelated with profitability.

JP Morgan is also a little bit unlucky here, in that it’s literally paying the price for misconduct at companies (WaMu and Bear Stearns) it wasn’t managing when the misconduct took place. Few of us are going to shed any tears as a result: those two acquisitions were still wildly profitable for JP Morgan even after accounting for all their associated legal liabilities. But it is a bit of a stretch to blame Jamie Dimon personally for actions which took place at rival banks, before he bought those banks.

But it’s the third possibility which is the most intriguing. JP Morgan is hardly alone in having engaged in the kind of behavior which has produced all these fines — but it is alone in building up a $23 billion reserve against future legal costs, and spending $9.2 billion on such things in a single quarter. Were Washington Mutual and Bear Stearns really worse than Countrywide and Merrill Lynch? If not, how come it’s JP Morgan with the legal losses, and not Bank of America as well?

One theme running through the aftermath of the financial crisis is that banks have to some extent been insulated from being held accountable for their actions by fears that aggressive prosecutions could endanger America’s fragile economic recovery. We’re trying to recapitalize the banks, trying to get them to lend more; if we simply suck out all their capital in the form of fines, then that will only serve to weaken them. If that’s a real fear, and I think it probably is, in corners of Washington, then it makes sense that JP Morgan would be the biggest target of prosecutorial zeal — just because it’s the bank with the strongest balance sheet, and therefore the bank which is most capable of paying big fines.

None of which in any way excuses JP Morgan’s actions, or implies that the fines it’s suffering are any less than fully deserved. It just implies that weaker banks might also deserve such massive fines as well — and are managing to avoid them only because they have less ability to pay them.

I’m fine with this possibility. When the Obama administration was forced to decide whether or not to nationalize America’s biggest banks, it knew that one of the consequences of its ultimate choice — not to nationalize — was that it would see less upside if and when its bailout worked. So in a weird way, JP Morgan’s current legal woes are a way of it paying the US government back for all the help we gave the bank during and after the financial crisis.

Think about it this way: let’s say you went up to Jamie Dimon during the height of the crisis, and told him that the Fed would implement an all-out flood of liquidity, and the Bush and Obama administrations would stop at nothing in their attempts to rescue the financial system, on one condition. The bargain would be this: if all those efforts worked, and JP Morgan ended up as a bank making $6 billion per quarter in profits, then at that point it would have to fully atone, with a few quarters’ profits, for its own sins and those of the banks it wanted to acquire. JP Morgan’s solvency and capital adequacy would be guaranteed: it would only face the fines if it was more than capable of paying them.

Dimon would have jumped at such a bargain, and so would any other bank CEO. (Well, maybe not Dick Fuld.) As a result, JP Morgan’s fines are entirely fair. They are deserved on a narrow basis, and they are easily within the bank’s ability to repay. The only reason for Dimon to feel hard done by, here, is if he thinks that rival banks are getting off easier than he is, just because they’ve got less money. That might be the case. But that doesn’t mean he’d be willing to trade places with them.

COMMENT

I guess this falls under #1, but JPM has done more damage than is widely recognized. One example comes from the Chase credit card, where fixed rate “for the life of the loan” balance transfers were agressively marketed while the prime rate was MUCH higher than the offered rate. Apparently, the expectation that most would mess up and end up paying the higher rates that come after a mistake. When that did not occur across the board and the prime rate got below the promotional rate, Chase hit the responsible borrowers with a 5% minimum payment.

Perhaps this was Gordon Smith and not Jamie Dimon, but it drove some to bankruptcy. There was a class action settlement but that reaped more reward for attorneys than for those harmed. As one harmed, I have a difficult time fining any fine too large for this company.

Posted by nprfreak | Report as abusive
  •