Forget Volcker — bring back Glass-Steagall
Imagine you are a financial regulator whose agency is underfunded, understaffed and under-trained and that firms under your jurisdiction are likely to pick off your best employees by offering them triple the salary you pay them.
Furthermore, imagine that Congress has written an 800-page law that instructs you to write and enforce new regulations on banks and securities firms to ensure financial stability for the system. The most complex part of this new law, the Volcker Rule, would require you to cooperate with three other agencies to jointly issue a 530-page Proposed Rule that asks 1,300 questions.
Now imagine that in the course of honing this rule, 17,000 comment letters will flow into your agency, the majority of which promote the status quo.
After going through this thought experiment, you’d probably say: “What a headache! Why can’t we just bring back Glass-Steagall and split up banks into risky trading machines and safe depository institutions? This monstrosity of a regulatory fiat will never be properly defined or adequately enforced.”
The Volcker Rule is supposed to isolate the risk of a bank trading its own assets and separate that from depositors’ assets. In other words, the Volcker Rule should isolate the risk of a big derivatives or fixed-income loss on the house account from the cash savings of retired teachers and other customers of the bank. By design, it is aimed at the heart of the nation’s largest banks, the five institutions that use their enormous staffs and FDIC-insured balance sheets to dominate trading and commercial banking.
Take JPMorgan Chase, for instance. Tuesday it released the employee headcount of its investment bank: 2,500 salespeople and 2,000 traders on 110 trading desks in 20 trading centers, in addition to its 2,000 investment bankers. JPMorgan trades securities in 12 asset classes using its risk-weighted assets of $467 billion. Although JPMorgan and other banks are less leveraged than they were prior to the financial crisis, they are still pumped up trading engines attached to slow-moving, deposit-taking banks. In the derivative space alone JP Morgan’s total credit exposure was 285 percent of its risk-based capital in Q3 2011, according to the Office of the Comptroller of the Currency (graph 5A).
The core issue in attempting to define the Volcker Rule is that federal securities and banking regulators have never really supervised the fixed-income and derivatives markets. Dodd-Frank has many provisions for the regulation of derivatives but entirely skips over any requirement to regulate bond trading. The SEC heavily regulates stock trading but conducts little to no oversight of bond markets. Bonds are an enormous, dark market that few people understand, hence all the laments that eliminating prop trading of bonds will dry up liquidity — a ridiculous idea. If there are larger profits in bond trading because the five major banks are limited, new entrants will expand into the market to capture those profits and provide liquidity.
Buying the top spot in the muni league table
Bloomberg ran an excellent story recently about JP Morgan making a very low bid to win the underwriting role for Massachusetts’ latest general obligation bond offering. The bid reduced the interest rate the state will pay for the borrowed funds and vaulted JP Morgan to the top of the league table to finish the year. Slashing fees to move up league tables happens all the time in financial markets, but it’s unusual to hear the particulars:
The competition between JPMorgan Chase & Co. (JPM) and Bank of America Merrill Lynch to be the top underwriter of municipal bonds offered by auction helped Massachusetts save $880,000 on a $400 million borrowing.
JPMorgan won the bid Dec. 20 for the general-obligation debt maturing from 2015 to 2027, offering an overall interest cost of 2.57 percent, according to state Treasurer Steven Grossman. Bank of America Merrill Lynch was the second-lowest bidder, offering 2.79 percent. With the Massachusetts deal, JPMorgan vaulted ahead of Bank of America for the top underwriter of competitive municipal bonds issued in 2011 by $141 million, according to data compiled by Bloomberg.
The lower rate JP Morgan offered to Massachusetts doesn’t necessarily mean that the bank will be paid less to bring the deal to market. It just means they believe they can rustle up better demand for the Massachusetts bonds among their clients and sell the bonds at a higher price (hence the lower interest rate for the issuer). The Official Statement for the bond offering says (page 6) that JP Morgan will earn approximately $1,895,000 for bringing the deal:
If all of the Bonds were resold to the public at such yields, the purchaser of the Bonds has informed the Commonwealth that its total compensation is expected to be 0.4738%.
If JP Morgan is unable to sell the bonds at the projected price, then they will absorb the difference between what they paid Massachusetts to buy the bonds and what they are able to sell them for. But the municipal market is very robust and they are likely to find strong demand. If demand was weak for some reason it would be reasonable for JP Morgan to hold these bonds on their balance sheet or pledge them for borrowing. For a bank with a strong balance sheet, there are a lot of ways to play this deal. Both Massachusetts and JP Morgan won in this transaction.
Matt Taibbi had a story about this bond deal @ Rolling Stone:
http://www.rollingstone.com/politics/blo gs/taibblog/how-banks-cheat-taxpayers-20 111227
Only 20% of bond underwriting is competitively bid.
Make Jefferson County’s receiver its salesman
The story of Jefferson County, Alabama filing the largest municipal bankruptcy ever last week is well-known. The county went into hock for about $3 billion to build an EPA-mandated sewer system. On the way to completing the system, every local crook and corrupt politician piled onto the project to skim off some pork. Many of these players ended up in prison and left the taxpayers saddled with a sewer system they really can’t afford.
Last year, amid the county’s fiscal and political meltdown, the Russell County Circuit Court appointed a water system professional, John Young, to take over the management and operation of the sewer system. This action came at the request of the bond indenture trustee, the Bank of New York, which wanted the bond payments protected. Now the county is fighting with the receiver and creditors for control of the sewer system in bankruptcy court. My advice to Jefferson County Commissioners is to stop fighting John Young and change his role into a salesman for the system. The sewer system is an albatross, and it should be sold and creditors repaid with the sale proceeds.
The Russell County Circuit Court’s mandate covered raising sewer rates and lowering costs but did not grant Mr. Young a role in facilitating a settlement with sewer debt creditors. According to Young, he took on that responsibility “unofficially.” He claimed to have traveled many times to New York City to negotiate potential haircuts on the outstanding debt, meeting repeatedly with JP Morgan, the biggest creditor, and other Wall Street banks. Young had a lot of experience dealing with Wall Street as the former president of the publicly-held American Water Works Company.
There is a lot of animus towards John Young in Jefferson County because he has been paid over $1 million in the last year and is perceived to be representing Wall Street instead of taxpayers. The Jefferson County political elite, from U.S. Representative Spencer Bachus to the Jefferson County delegation to the state legislature (shown in the video above), want John Young out of the county’s affairs. The Commissioners of Jefferson County filed a motion in federal bankruptcy to remove Young as the sewer system receiver. That motion will be argued on Monday.
I attended a luncheon yesterday of the Municipal Analysts Group of New York where John Young talked about his role running the sewer system, his trips to New York to meet with creditors and his current fight to retain control of the system in bankruptcy. What was clear from his presentation was that the sewer utility that he found when he stepped into the receiver role was run as a comfortable, good-ol’-boy operation with few management controls. He said that no income statement, balance sheet or long-term business plan had been developed for the system. As someone coming from a shareholder-owned company he first set to work getting operational metrics and cost accounting in place. Imagine transforming an utility that had just spent billions on infrastructure with few controls into a cost-driven operation. It’s a mighty feat.
Crawling in the dark through the muni CDS market
I’m beginning to think that Europe’s sovereign debt crisis might kill more than municipal credit default swaps. As the financial system trembles alongside the deliberations of the Greek government, areas of the markets that have quietly lumbered along in the dark are getting more and more attention.
Bloomberg held an excellent state and local finance conference on Wednesday where there was a brilliant session with the state treasurers of North Carolina, Delaware and New Jersey. Bloomberg Editor-in-Chief Matt Winkler grilled the trio on the use of derivatives, mainly interest rate swaps, by public officials. In the most thought-provoking back-and-forth, Winkler asked what the difference was between Alabama’s Jeffereson County and Greece. Both Greece and Jefferson County have extensive ties to financial institutions through the bonds they issued and derivatives they have either entered into or that have been written on them. In the case of Jefferson County this exposure is mainly concentrated with JP Morgan Chase, the lead underwriter for most of the bonds and derivatives written on the county. In the case of Greece it’s fairly well-known who owns its bonds but it’s practically unknown how deep the interconnections are for derivatives. As Bloomberg wrote:
The European nations are linked in a network of debts, as Bill Marsh recently illustrated in the New York Times with a beautiful piece of graphic art. The image is like a complex wiring diagram for a ticking debt bomb. Yet what it shows may be less important than what it leaves out: a largely invisible network of ties among institutions around the world, which could ultimately cause global financial chaos.
This hidden network has been created by institutions that buy and sell unregulated credit-default swaps. These are essentially insurance contracts on bonds; in the event of a default on the bond, the seller of the swap promises to pay the buyer the bond’s value.
This web of interconnections is amplified many times over because of the intense concentration of derivatives on the trading books of a handful of large, global banks. The graph below from the blog Jesse’s Cafe shows the level of concentration for U.S. commercial banks using data from the Office of the Comptroller of the Currency (OCC). Basically five U.S. banks control the whole U.S. market and embody the concentrated risk. A publication from ISDA, the trade association that represents the large, global banks in the derivatives area, said the OCC reported the notional amount of derivatives outstanding at the five largest U.S.-based dealers was $281 trillion as of June 30, 2010. That is a massive spiderweb of risk given that the U.S. annual GDP is about $14 trillion.
Let Europe kill municipal CDS
The solution to Greece’s debt crisis that Europe’s leaders announced on Thursday has market participants and commentators howling. It includes a provision that changes long-established rules for credit-default swaps mid-game. Mike Dolan, Reuters’ Investment Strategy Editor in Europe, said this:
For all the ifs and buts about the latest euro rescue agreement, one of its most profound market legacies may be to sound the death knell for sovereign credit default swaps — at least those covering richer developed economies.
I’d suggest that death knell just rang for U.S. municipal credit-default swaps (CDS), too. They’ve recently been on their last legs amid collapsing volumes, but actions in Europe just might have delivered the deathblow.
Credit-default swaps play an arcane role in financial markets. Firms allegedly buy them for protection against the default of bonds they hold in their portfolios. For example, if XYZ Investment Group owned $10 million worth of Greek government bonds that matured in 10 years (GGGB10YR:IND) and the Greek government couldn’t pay their obligations, then the seller of the CDS would step in and pay the CDS owner. Think of the CDS seller as a guarantor or insurance provider of sorts.
CDS are marketed as protection against the risk of default of the cash bond that they reference. Contrary to standing convention though, when the announcement was made that Greek bondholders would be asked to take a 50 percent haircut (or markdown) on the value of their bonds, the CDS governing group announced they would not be triggered. Their rationale was that the bond swap would not be compulsory and that CDS sellers would not need to make payouts to make up losses. Here is how a twitter user responded:
@amb5160 amb5160 the real story today is that CDS, a multi billion (trillion??) dollar asset class is GONE in one day! no more quotes on bberg. insanity
Why invest in insurance if the insurer says no payment is necessary because we have new conditions? It’s easy to understand the outrage.
I was under the impression that ISDA had not made a ruling yet on whether the haircut would be considered a default event triggering payment. If they do not it, I agree it will be a disaster for the cds market.
The weakest states are stronger than U.S. banks
The weakest states are stronger than US banks
I noticed something very interesting in some research that Markit, a data provider that tracks the credit-default swap market, released yesterday: the worst U.S. municipal credits (California, Illinois and New Jersey) are considered much stronger than all the major U.S. banks save JP Morgan. New York state is considered stronger than Mr. Dimon’s bank!
Why this is especially important in muniland is that these U.S. banks write a lot of credit-default swaps insuring the debt of these large states, which seems upside-down given that credit markets view the banks as weaker than the states they insure. This raises questions about the validity of the whole muni CDS market. I’ll dig around on this issue a little more.
Heavy political support for ending municipal-bond tax exemption
Bloomberg writes about several strong political forces in favor of ending the tax exclusion from municipal bond interest payments. I still haven’t seen a definitive cost analysis of the change though. Maybe the President’s proposal to reduce the tax exclusion on muni bonds for those earning over $200,000 is a signal to Republicans that the administration is willing to negotiate the issue. From Bloomberg:
The idea of phasing out the exemption has been raised in the past year as part of a broader discussion of ways to reduce the federal deficit. A proposal in the House of Representatives by Budget Committee Chairman Paul Ryan, a Wisconsin Republican, sought an end to the break.
A report from Obama’s 2010 fiscal commission led by Alan Simpson and Erskin Bowles, which the president embraced in December, also proposed ending the exemption, Bank of New York Mellon Corp. said in a report.
The break is the 11th biggest for taxpayers after such deductible expenses as employer-provided health coverage and home-mortgage interest, according to White House data.
Yet limiting the exemption for higher-income taxpayers may produce relatively little benefit, Harvey said in a statement released with the report. In 2008, for instance, “more than half of the 5.5 million tax returns reporting receipt of tax- exempt interest were filed by taxpayers with adjusted gross income below $100,000.”
“Maybe the President’s proposal to reduce the tax exclusion on muni bonds for those earning over $200,000 is a signal to Republicans that the administration is willing to negotiate the issue.”
Isn’t that part of the “unless you do something, this will happen because you insisted on it” part of the (real) American Jobs Act? That’s not “open to negotiation,” that’s “this will get them to do something.”
“We don’t have a deal”
The Jefferson County Commission met last Friday to decide if they would accept a proposed settlement from creditors led by JP Morgan on their $3 billion of sewer debt. After many hours of meeting in executive session and in public, the Commission voted to reject the proposal, remove the court appointed receiver and directly negotiate with the creditors.
I watched the live webcast of the meeting and it was actually one of the most open and informed county commission meetings that I’ve ever seen. I give the Commissioners a lot of credit for their efforts to clean up a problem which they did not create. In the meeting there was a lot of indignation against JP Morgan and their role in burdening the county with several billion dollars of derivatives. Several Commissioners felt especially that there had been fraud in these transactions and were not willing to release their right to sue JP Morgan and other banks for these problems. There were also calls for increased transparency in the process. There was a lot of drama in the meeting.
The drama was only heightened when county commissioner, T. Joe Knight, saw a message on his mobile device in the middle of the meeting that said the Wall Street Journal was running a headline announcing that an agreement had been reached. You can see the video of Commissioner Knight above shouting, “We don’t have a deal”. When I clicked over to the WSJ.com the paper was running a story that quoted the state finance director and said that the Commission had accepted the proposal although the Commission had not yet voted. The Wall Street Journal eventually yanked the false story and replaced it with this account which makes their error seem less odious:
As Friday’s closed-door meeting was ending, an Alabama official sent out an email to a reporter saying that commissioners “appear to have a conceptual agreement in place for settlement.” After reading Wall Street Journal headlines about the announcement, commissioner Joe Knight threw down his mobile device, saying: “We don’t have a deal.”
Here is the Twitter thread:
cate_long Cate Long
Watch Jefferson County Commission hearing live
The Jefferson County Commission is meeting now to review a counter-proposals from creditors lead by JP Morgan and decide whether to accept it or file for Chapter 9 bankruptcy. Live feed via the Birmingham News.
To recap, Jefferson County, Alabama is getting a lot of attention as it negotiates with the holders of $3 billion of sewer bonds. The county would like to pay $2 billion to settle the $3 billion of bonds outstanding and limit the rate increases county residents would have to pay. This arrangement would pay bondholders (led by JP Morgan) 66 cents on the dollar — not a great recovery but not outrageous either. Bondholders want the state to guarantee this new arrangement and stand ready to pay in the event of another default.
Update on creditor offer terms (August 12, 2011) via the Birmingham News:
THE CREDITORS’ NEW PLAN
> Refinance a principal amount of $2.326 billion, with $233 million going into a debt service reserve, $23.3 million paying issuance costs and $2.07 billion to redeem all outstanding sewer warrants based on negotiated concessions.
> Create an independent public corporation to own, manage and finance the sewer system.
Geeks for democracy
Geeks for democracy
“How do you enable people to have a louder voice within their communities?” asks Conor White-Sullivan. He answered his own question by developing Localocracy, a platform that hosts community-focused discussion boards seeking participants who are registered to vote and who use their real names. Localocracy gives citizens an opportunity to generate discussions to influence each other, their government and journalists.
Conor is one of 16 winners of “Champions of Change,” a contest the White House hosted in June that showcased the potential of Web apps that utilize data sets made available by federal, state and local agencies. Developers who were chosen to attend created applications that enable users to find and organize pick-up games at public facilities, guide citizens through zoning ordinances and direct parents to child-friendly locations, as well as numerous other services. See more of this wonderful project at GovTech.com.
Jefferson County part 6
According to the Birmingham News the court-appointed receiver over the Jefferson County sewer system, John S. Young, announced late Wednesday that the bondholders had a counter-proposal for the county commission. This was a few short hours before the commission’s 1:00pm meeting today to decide to declare bankruptcy.
Mr. Young had not shared the proposal with the commission as of last night, according to county officials. But he was quick to speak to the press. I think Mr. Young should be communicating with the debtors rather than the media. The time is long past for this kabuki. All parties in this transaction must deal in the highest standards of good faith.
The state becomes the guarantor
Jefferson County, Alabama is getting a lot of attention as it negotiates with the holders of $3 billion of sewer bonds. The county would like to pay $2 billion to settle the $3 billion of bonds outstanding and limit the rate increases county residents would have to pay. This arrangement would pay bondholders (led by JP Morgan) 66 cents on the dollar — not a great recovery but not outrageous either. Bondholders want the state to guarantee this new arrangement and stand ready to pay in the event of another default.
There is an alternative option for settling the matter: a Chapter 9 municipal bankruptcy. The county is now prepared to go that route if necessary and have hired an expert attorney to lead them through the process if they so choose.
The county accumulated this sewer debt over a number of years to fund the development of an EPA-mandated sewer system. Its construction was laced with delays, cost overruns and corruption. It’s the poster child for disastrous public works and bad dealing by Wall Street. The credit rating for this debt started out as AAA in 1997 when it was issued. The bond insurer FGIC stood behind the debt and helped raise the credit to the highest level, AAA, from Baa1. In the chart above you can see the rating move in February 1997 as the insurer came in and pledged to repay bondholders if default occurred.
Jefferson County issued another very large amount of bonds in 2003 to pay for project overruns. This caused the rating on these earlier 1997 bonds to be lowered. This is due to the Jefferson County now having a heavier debt load to service. Credit ratings are a reflection of an issuer’s ability to carry and service the debt they have outstanding.
The financial crisis of 2008 decimated the bond insurer and caused Jefferson County’s rating to plunge. The rating briefly spiked in March 2008 as the guarantor briefly recapitalized their business. Since then the rating has been sinking lower and reflects that these bonds are near default.
The state of Alabama could be a good guarantor of the bonds for Jefferson County, and there appears to some political willingness to do this. The rating agency Standard and Poor’s rates the state as AA and says (emphasis mine):
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Resident Muniland expert
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It’s true that there aren’t quote reporting requirements in the bond markets like there are in the stock markets. But that’s because there are literally millions of distinct bonds outstanding versus around 8,000 equities. It is impossible to quote all bonds actively as is done with equities. Dealers only provide bond quotes when their customers ask. And, there are detailed FINRA and MSRB markup and fair pricing rules that apply to the prices dealers dealers can charge for bonds. Moreover, the rules related to price transparency are completely unrelated to Gramm Leach Bliley and wouldn’t change if Glass Stegall came back. The GLBA had practically nothing to do with regulating the bond markets.
Even more important, there are extensive regulations that apply to almost all aspects of the bond markets. The SEC, FINRA and the MSRB all have thick rule books that relate to the bond business, and those rule books are getting thicker as Dodd-Frank is implemented. It simply isn’t the case that regulators conduct “little to no oversight of bond markets.”
Finally, under Glass-Stegall before the GLBA, banks were heavily involved in the fixed income markets. Government, agency, mortgage-backed and most municipal securities were all “bank eligible,” meaning that commercial banks could underwrite and trade them. Bringing back Glass-Stegall as it was before the GLBA wouldn’t keep banks out of the fixed income business.