Bailout: It's About Capital, Not Liquidity; Seeking Beta: Interview with Robert Arvanitis
September 29, 2008
Last week also made us very aware of the privilege and responsibility we have at IRA to have access to the Big Media. Our friends at CNBC, Bloomberg, the New York Times, and many other print and broadcast outlets have generously given us enormous visibility over the past few months. As we travel around the country, people now stop us on the street, the train, in the lobbies of office building and airports, to ask: "What the hell is going on with the banks?" We appreciate the fact that people care about our views and we will work to deserve such confidence.
Finally, we want to thank the hundreds of readers, new and old, that we have heard from in the past week, supporting many of the opinions we express about the financial assistance legislation being formulated in Washington. The few who did not support our views at least appreciate our efforts. Said one reader: "It would make your ideas more palatable if they were presented with a little humility and a recognition that you are not infallible." Let us just state for the record that we are not sure of anything at the moment, but we put faith in first principles of individual freedom and responsibility to guide our efforts. And please do keep those cards and letters coming.
Memo to Ben Bernanke & Hank Paulson: Confidence is a Function of Capital, Not Liquidity
During the presidential debates on Friday, Senator John McCain (R-AZ) said that we are "at the end of the beginning" of the economic recession that is affecting the US and the entire world. We completely agree. So let us try to describe in financial terms why we believe that the legislation currently being finalized in Washington will be ineffective in achieving the stated goal of restoring liquidity to financial institutions and thereby make it possible for banks to begin to expand their balance sheets and lending books, both of which are currently contracting at an alarming and accelerating rate. In a soon to be published article by Alex Pollock and John Makin, both of American Enterprise Institute, "The RTC or the RFC: Taxpayers as Involuntary Equity Investors," the two respected financial observers write:
"Do we need a 'new RTC' as the U.S. Treasury is proposing-or something else? We believe that an alternative framework is needed. Its key elements should be two: recognition of systemic risk embedded in the illiquidity of mortgage-backed securities and capture of the upside of a rescue for taxpayers, not for banks and (former) investment banks that created the bubble…. A better model for a fair solution to the incipient solvency problem is the Reconstruction Finance Corporation, or RFC, of the 1930s. This was one of the most powerful and effective of the agencies created to cope with the greatest U.S. financial crisis ever. When financial losses have been so great as to run through bank capital, when waiting and hoping have not succeeded, when uncertainty is extreme and risk premia therefore elevated, what the firms involved need is not more debt, but more equity capital."
Pollock and Makin point out that simply buying bad assets from banks does not solve the most basic problem, naming restoring confidence in one another among financial institutions by ending questions regarding solvency. In this regard, click here to see a proposal circulated by and among individual members of Professional Risk Managers International Association over the weekend. The plan has two big virtues from our perspective: 1) it minimizes the outlays by the Treasury by keeping bad assets in private hands and 2) it provides a capital facility for solvent banks, a provision that is missing from the drafts we've seen of the assistance proposal now under consideration in Washington.
It is important for all Americans to understand that this financial crisis began more than a year ago with the collapse of liquidity in many types of mortgage assets, but the battle is quickly shifting to concerns about capital and solvency. The Federal Reserve System, Federal Home Loan Banks and the Treasury have already advanced huge amounts of liquidity in the form of debt to financial institutions in an attempt to help them stabilize their funding sources and slowly begin to re-liquefy. Click here to see a map of the balance sheet of the Federal Reserve Bank of New York maintained by our friends at Cumberland Advisers. But unfortunately neither these existing sources of funding nor the proposal to provide even more debt-financed support gets to the core issue that is undermining in the financial system, namely worries about solvency.
Consider two models for government assistance. The first is the Resolution Trust Corporation ("RTC") model of the 1980s, which was used to buy up bad assets following the S&L crisis of the 1980s. The older model comes from the 1930s and the Reconstruction Finance Corporation ("RFC"), the most authoritarian federal agency that has ever existed in the United States. Directed by Jesse R. Jones, the RFC used its vast legal powers to test the solvency of banks and commercial companies and, when those institutions were proven solvent, they were allowed to re-open. Those financial institutions that were determined not to be solvent were closed by the FDIC and either sold whole or in pieces to other institutions.
Below are two very simplified numerical illustrations to highlight the failings of the current plan in Washington by way of a comparison between (1) the RTC/Paulson model and (2) the 1930s RFC model, which is conveniently illustrated by the purchase of WaMu by JPMorgan Chase (NYSE:JPM). Of note, in the WaMu resolution, equity and bond holders of the parent holding company were effectively wiped out - a significant landmark for bank investors that probably kills the private market for bank equity for the foreseeable future. Significantly, the advances from the FHLBs and the covered bonds issued by WaMu's bank subsidiary were conveyed through the receivership and assumed by JPM. More on this in our next comment.
The RTC/Paulson Model
Suppose the Treasury's bailout fund purchases $1 billion dollars worth of illiquid assets from a participating bank at par value, which for laymen is the face value of a loan or security. In that $1 billion, the bank actually receives $900 million of cash that was raised via deposits or other forms of debt and $100 million in its own capital, assuming a 10:1 leverage ratio. This is how bank operations work, a little bit of capital and a lot of leverage -- as described in the Jimmy Stewart film "Its a Wonderful Life." If the bank sells assets to the Treasury below par value (or the current, adjusted value if an adjustment or write-down has already been made), then the selling bank takes a capital loss and the other providers of liquidity, whether via deposits, debts or official sources of funding like the Federal Reserve System and Federal Home Loan Banks, are also taking an implicit if as yet unrealized loss.
In this first example, the overall solvency of the bank is actually hurt and the issues of confidence and safety and soundness are left unresolved or even worsened. This is why we believe the proposal being considered in Washington will be ineffective at best and may actually worsen the crisis of confidence in US banks. The RTC/Paulson model does nothing to arrest the de-leveraging of the commercial banking system and may even worsen the crisis of confidence. In our view, Senator Dick Shelby (R-AL), the House Republicans and the members of either party who want to have political careers in two year's time are right to vote no on this proposal.
The RFC/WaMu Model
In the second example, imagine that Treasury takes a $1 billion preferred equity position in a solvent but illiquid bank. Instead of only receiving 10% of the amount of the cash infusion from the Treasury as capital, the bank receives the full $1 billion as new capital to absorb losses and then serve as a basis to re-lever the bank's balance sheet and make new loans. By putting capital into solvent but illiquid banks, the Treasury can help them to offset losses of existing assets and provide new capital to use to make new loans to support the real economy. Remember, when new capital is invested in a bank under the RFC model, all of those funds are available to support the bank's balance sheet, including deposits and bond holders.
If an insolvent bank is resolved by the FDIC, but its asset quality problems are too severe for a purchaser to assume the full burden of dealing with these assets (unlike the JPM/WaMu transaction), then the Treasury bailout fund could subsidize the transaction by purchasing preferred equity in the purchaser and providing a small but still significant option for the taxpayer to benefit from any recovery on the failed bank's assets. This allows the FDIC to minimize the number of troubled institutions that it must operate as receiver and keeps the troubled assets in private hands, where the cost of resolution will be minimized in order to maximize profit. But as suggested by the proposal advanced by individual members of PRMIA mentioned at the top of this comment, the first goal is to keep as many banks and assets as possible out of government hands.
The difference between the current, RTC type model and the 1930s RFC model can be summarized succinctly: The bailout proposal now before Congress does not deal sufficiently with the issue of solvency and ensures that the US banking system will continue to deflate and de-lever, meaning that less and less credit will be available to the private economy and the recession is likely to be far longer and deeper. The present situation in the US economy is not nearly as bad as the 1930s, but if Ben Bernanke and Hank Paulson don't soon refocus their attention from liquidity to solvency of depository institutions, the US economy could end up in a situation that is much worse that the 1930s given the huge inflation of asset values seen over the past decade. This situation is soluable and can be quickly repaired, but only if we make capital and the leverage it can support work for us, not aganst us as is now the case.
With the RFC model, on the other hand, by quickly moving to inject capital into solvent banks, we can actually reverse the process of deleveraging and deflation that is currently grinding the global banking system -- and the world economy -- into the ground. By using new leverage and private capital, we can not only re-liquefy the banking system but also decrease the length and severity of the now present recession. As we've said before and will no doubt say again, the roadmap for how to achieve this positive end is in Jones' memoir, Fifty Billion Dollars: My Thirteen Years at the RFC. We know for a fact that the Library of Congress has many copies of this excellent book as well as copies of the congressional hearings regarding the creation of the RFC and Jones' periodic reports to the Congress. But will anyone in Washington bother to read them?
Seeking Beta: Interview with Robert Arvanitis
Robert Arvanitis of Risk Finance Advisers is a Wall Street veteran who has managed to avoid some of the more spectacular disasters in recent financial history. An actuary by training and a member of PRMIA, he learned the reinsurance business from Hank Greenberg at AIG. Seeing the need to broaden the industry model, he moved into investment banking. At Merrill Lynch (NYSE:MER) he was managing director of Global New Derivatives, responsible for the very first "catastrophe" bond, among other innovations. Robert took the money off the table just in time, leaving MER before the dot.com bust. He now has the leisure to pursue the cross-sector arbs between insurance and banking, as we discuss below.
The IRA: Bob, we've been wanting to talk to you for some time about the current financial crisis. You have a unique perspective given your work in both the insurance and banking worlds.
Arvanitis: My first observation is that we do not learn from the past - we find new and more subtle errors to commit. History does not repeat itself, people repeat the same mistakes over and over. Second, in the case of the financial markets, they are perpetually slicing and dicing what they know because they cannot have access to or understand what they don't know. They only way to break out of these well-worn paths, the familiar X/Y plane is go off in a different direction, call it Z. The insurance industry deals with wind and death and hurricanes, while Wall Street deals with what's described in the Bloomberg terminal. BTW, I also have just described the difference between mark-to-market and buy and hold forever.
The IRA: Give us an example of the law of repetition.
Arvanitis: Back in the late '80s, a interesting thing happened at Lloyd's of London, the famous insurance marketplace. That venerable institution was driven by a host of forces to seek growth, find new revenue sources.
The IRA: Sounds like Wall Street post-deregulation.
Arvanitis: Oh yes. Since insurance only grows naturally with the overall economy, the clever brokers at Lloyd's hit on a new scheme. When an insurer has too much risk, it often reinsures itself, or passes risk on to a reinsurer. Reinsurers do likewise to protect themselves, and retrocede risk on to another reinsurer. Well to keep revenues growing, the London brokers started a chain, call it the London Market Excess ("LMX"). They circulated risks 'round and 'round from insurer to reinsurer to retrocessionaire, each time taking out a commission bite, and at each step, losing details about the actual underlying risks. This "LMX Spiral" was a great game for a while. Eventually, of course, claims had to be settled. With the loss of detail at each turn of the spiral, that was hard. Even worse, after all the brokers' commissions, there was no money left to actually pay claims.
The IRA: Why does AIG, MBIA (NYSE:MBI) and Ambac (NYSE:ABK) spring to mind? Also nicely describes securitization.
Arvanitis: Precisely. Roll forward twenty years. An interesting thing happened on Wall Street. The banks found themselves driven by a host of forces to seek growth, find new revenue sources. Since true investment and commercial banking only grows naturally with the overall economy, the clever bankers of Wall Street hit on a new scheme. When a bank has too much risk, it often sells assets, or borrows, or both, since that's cheaper than raising equity. But then the bank needs to create new assets, for fee income, for market share, and not least to keep its origination channels busy and loyal.
The IRA: We call it "yield to commission."
Arvanitis: Well to keep revenues growing, Wall Street started a chain, call it the CDO excess spiral. Package assets. Circulate them. Buy pieces, re-package and re-circulate, taking out a commission bite at each step. This CDO spiral was a great game for a while. Eventually of course, assets had to perform. With the same risks in every package, correlations soared to 1. In the end, there was no money in the smallest Matryoshka doll.
The IRA: Why do such spirals happen?
Arvanitis: Well, it happened at Lloyds because with insurance, the brokers who distribute are distinct from, and competitive with, the underwriters who take the risks. This came about because from the start in shipping, a sinking loss was far too big for any one underwriter, so all risks were syndicated. Distribution grew up as an independent function. Capital markets are more sophisticated. Distribution and underwriting are under one roof, albeit separated by a Chinese wall. So we don't find one function merely cozening the other. No, in banking we must resort to more subtle errors, deeper flaws in the system.
The IRA: Why does this not make us feel good…
Arvanitis: Because you and Dennis are honest analysts who don't work for broker dealers, at least in your case not any longer. I too am a refugee. The flaw in capital markets is the Rube Goldberg apparatus that passes for regulation. Whatever else history decides, the current financial contretemps did not result from lack of regulation. Rather, it arose from human weakness on both sides-industry and government. The amorality of industry is widely discussed. What is not so often recognized is the human weakness in government.
The IRA: Those weaknesses are very visible this week.
Arvanitis: Congress delegates to SEC, which delegates to PCAOB/FASB, which delegate to auditors, who hope that giving information to shareholders, on the theory that it will let them govern the boards, who in their own turn just may be able to rein in management. Meanwhile, Congress via ERISA tries to define "prudent." They do this by delegating great power - but not accountability - to rating agencies. Yet the NRSROs are paid by the Buy and Sell Side interests to say "Yes." Coming along after the fact, shareholder suits are a very blunt corrective. They increase uncertainty, and raise D&O premiums, but have no effect on management and emphatically do not discipline boards. This scheme is worse than no feedback mechanism at all for it deceives us into believing someone, somewhere, is responsible.
The IRA: As our friend Timothy Dickinson noted in an interview this year, the idea that institutions are led by people sufficiently informed to make rational decisions is an illusion ('The Tyranny of Reason: Interview with Timothy Dickinson', July 30, 2008).
Arvanitis: Precisely. With so many moving parts, no specific bureaucrat can ever be called to account. Being mortal, the bureaucrats desire to avoid pain is as dear to them as the desire by their counterparts in private industry to seek gain. And it is far more profitable to game the rules, for example, than to enforce them. And any system can be gamed. Witness the over-reaction of SarbOx, and the subsequent avoidance.
The IRA: So your answer is to focus on the Z axis, namely low beta transactions. Give our readers a clear, simple definition of the difference between Alpha and Beta.
Arvanitis: Alpha, to use the securities market example, is when an investor performs above the perceived level of risk. As risk goes to zero, if you have anything left, then you are making free money. Another way to put it is "I'm a genius." Of course, in the markets some people lose money, thus others make money due to those mistakes. But I personally believe that there is no "free" alpha. That said, there is a way to earn returns that may look like alpha, especially if you are an astute student of human nature. You can make a bet when other people are behaving irrationally, as when you buy when there is blood in the street.
The IRA: Or Warren Buffet buying a chunk of Goldman Sachs (NYSE:GS) as it was pushed into the arms of the Fed?
Arvanitis: Yes, but that is not really alpha. It does not come from the market but instead from human fallacy and exploitation thereof, like being a good salesman. So that is alpha. Beta means correlation to the market. If it is correlated to the market, then you should get paid like anybody else, namely union wages. If you take X risk then you get Y return, that is the market rate. No better, no worse, just the average.
The IRA: But you have chosen to focus your firm on brokering "low beta" risks. What is that?
Arvanitis: Low beta is uncorrelated, non-market risk. This is the type of risk that insurers used to price, the sinking of ships, hurricanes. Non-market, uncorrelated risks. Now 300 years before Harry Markowitz, landed English gentry instinctively realized that their money came from land rents and crops, so they put some of their money to work by investing in Lloyds of London. If the crop was good this year, but a few ships sank, you made money on crops and lost on ships. The next year, the crops were lousy but no ships sank, so you made money on insurance. Lloyds was the insurance industry's first effort at diversification and they stuck to their knitting and underwrote real world risk events like hurricanes and fires, which were uncorrelated to other markets.
The IRA: So what happened to the insurance industry? How did AIG, MBI and ABK get lured away from low beta into something as reckless and speculative as credit default swaps ("CDS")?
Arvanitis: The insurance industry grew out of its crib and now does more and more underwriting in high-beta risks. They sell liability insurance, D&O coverage, surety, and, good lord, they even get into bond insurance. CDS is a bridge even further removed from the basic, low-beta model from which insurance comes. The risk taken by insurers is more and more high beta, and by doing so they spoiled a perfectly good racket.
The IRA: Precisely. Why on earth would AIG or the monolines leave a low risk, double digit rate of return business to gamble on municipal bond issuers or CDS? Makes no sense. Were they just chasing earnings growth?
Arvanitis: If they were chasing earnings they'd be smart. They were chasing revenue. D&O liability is very high beta and far, far removed from the relatively uncorrelated risks upon which the insurance industry was built. Now this is where a great opportunity exists to create a new class of assets to feed to the insurers, pension funds, etc, who don't forget, still live largely in the world of buy-and-hold. By creating an asset based on whether there won't be a hurricane or that the wind does not blow in the Midwest at the wind farm, or that there is not sufficient traffic on the toll road, we can created a counter-cyclical bet. There are numerous ways to carve counter-cyclical trades out of capital markets transactions.
The IRA: So what's the problem? Why isn't Wall Street all over these types of low-beta transactions?
Arvanitis: Because the data needed to construct these transactions is not found on the Bloomberg and, let's face it, Wall Street rarely rewards imagination. If they did, you and I would be running Goldman Sachs or Morgan Stanley and those business models would be very different. It is hard to get a low beta transaction through the commitment or risk committee of a major bank because they cannot find a quote on wind or weather patterns on the Bloomberg terminal.
The IRA: Yes, we've been there. Back in the late 1990s, IRA co-founder Chris Whalen tried to get his colleagues at Bear, Stearns to look at a small, KS-based start up that wrote the original standard for the 802.11 wireless internet protocols. They said the opportunity was too small. We eventually showed the idea to Sony (NYSE:SNE), but they didn't get it either. But back on track, how do we deal with the mess on Wall Street? What would you tell members of Congress if you were in Washington today?
Arvanitis: As you state in the comment above this interview, it is all about capital. Firms need capital to demonstrate that they CAN hold assets to maturity. Therefore, they do NOT need to liquidate assets at distressed levels, so those assets ARE valuable. This, in turn, means the firm's equity is in good shape, so that it in fact HAS capital. The logic is quite circular. Capital is what you have in order that you do not ever need it.
The IRA: But now capital is in doubt because of the fear of insolvency, thus the need for new capital is infinite.
Arvanitis: Banks need capital against risk, but they also need new revenues to feed that capital. Hence the constant search for holes in the regulatory scheme, especially for wide margin assets. Of course the widest margins are in the most illiquid assets, and off we go. The FASB mark-to-market rule is truly an economists' nightmare. How can mark-to-market possibly matter in a market filled with illiquid assets? It merely lines up the dominos!
The IRA: Sadly, yes. As we pointed out last week, the FASB pricked the structured asset bubble that has caused the meltdown on Wall Street. I doubt any of the members of the FASB board understood the significance of their actions at the time. But by next year, enraged politicians and business leaders are going to be calling for the abolition of the FASB. If we were SEC Chairman Christopher Cox, FASB Chairman Bob Hertz or the other members of the FASB Board who voted to implement FAS 157, immigration would be on the top of the list of priorities for 2009.
Arvanitis: Well, here's the rub. We want to trade in the most illiquid assets, but can't afford to capitalize them without getting back on the circular mark-to-market spiral. Take my experience at MER as an example. When we did the very first "catastrophe" bond for USAA, we had to agent, not underwrite. Risk management officials at MER had no way to capitalize the bond for less than 100% if we positioned it. To solve this seeming problem, we must stop dealing with the full spread (on credit, or the equivalent full premium for equity.) Instead, we parse the spread into component drivers.
The IRA: Sounds a lot like the proposal from several PRMIA members we included in the top of this comment. Do continue.
Arvanitis: Traditionally, the market considers alpha, or "I'm a genius" returns, separately from beta, or "everyone gets paid" returns. The idea that there is ever a real alpha has been debunked repeatedly. Think "survivorship fallacy." So we're left with beta. It's in the low-beta markets that real value lies. But those are the risks which Wall Street finds so very hard to mark-to market or to capitalize.
The IRA: So is it an impossible task to reorient Wall Street to new opportunities?
Arvanitis: No. Enter the insurance sector, from above. Insurers emphatically do NOT price on blinking Bloomberg quotes. They use actuarial methods to price from first principles. And as hungry for revenue as they are, there is an enormous arbitrage opportunity between Wall Street's reaction-"we don't know what to do with this, so it's 100% capital"- and the insurer's price "We'll take it for 7¢."
The IRA: When the smoke clears from the meltdown on Wall Street, we'll come back to the "how to do it" discussion regarding low beta. Thanks Bob.
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