Credit Default Swaps and Too Big to Fail or Unwind: Interview With Ed Kane
June 3, 2009
First a housekeeping note. We are in the process of building out a new web site and online theme park for users of the IRA Bank Monitor consumer edition. This new domain is dedicated to serving the needs of the thousands of users of our consumer bank reports and Stress Index ratings for all US banks, as well as provide services for the banks that we rate. More to come as we make the site live and roll out new tools to serve the needs of both the consumers and the providers of banking services in future editions of The IRA.
We received a lot of reader feedback on our past two comments, but none more that the missive on credit default swaps or "CDS" and how the largest global banks are desperately trying preserve this deliberately unfair, deceptive OTC market from meaningful reform ("Kabuki on the Potomac: Reforming Credit Default Swaps and OTC Derivatives.").
We were especially impressed by a comment from an IRA reader, Bruce Krasting, a retired financial professional who's worked on both sides of the Street. To show just how small this world truly is, Bruce once lived down Mt. Airy Road from IRA co-founder Chris Whalen on the top of Red Hill in the Village of Croton-on-Hudson, NY. Or "Pink Hill" as Bruce and many locals call it. The definition of a Croton-on-Hudson communist is that when the FBI knocked on the door during the McCarthy years, the maid answered. The same observation could be made about most elected officials in the Democratic Party today.
Bruce now lives on the other side of the New Croton Dam in the Teatown Lake Reservation and frequently contributes comments to SeekingAlpha and other financial portals. He makes some important observations about the accounting reality behind the world of CDS and bank revenues generally. We share same with the readers of The IRA with his permission.
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More on CDS and Kabuki on the Potomac
Very interesting piece on the Kabuki. I think there is another angle to the banks trying to hold their control over CDS. It is accounting.
Simplistic example. You are a bank. You have two customers. Southwest Airlines (NYSE:LUV) and Chevron (NYSE:CVX). SW calls and says, "Lets do a deal. Every 6 months for five years we will swap money based on 1 mm barrels of oil at $60. If the then cash price is less than $60 I pay you. If it is more than $60 you pay me."
You say "fine" and then call Chevron. You enter into the exact opposite of the first swap trade. You make money doing this. You have a matched book. As a result of your purchases and sales you will have $50,000 in profit every six months for the next five years or a total locked in gain of $500,000.
At the end of the day your boss asks, "How did you do today?" You answer, "we made $500,000". He says, "Great. Here is your bonus". If you went to three market makers who did exactly the same as you did on that day the profit and loss results might be significantly different. For example:
- One could report a gain of $500,000. That would be justified. But would overstate the economic results
- Another might just record a gain of $100K (the current year portion that is "locked in"). The balance of the income is realized annually for five years. This would understate income. No one like that.
- Yet another might book just $400K of gains currently. This would represent the NPV of the $500k over the five-year period based on an internal capital rate set by the banks management. This is close to economic reality and is the form that most banks use to value this type of business. While it is the most appropriate and reasonable approach, it too is badly flawed.
The next day your bank announces quarterly earnings and says, "We made $400K. We are paying a dividend based on that and we are paying bonuses based on that. Net-net, retained earnings will go up by $250,000. It was a good quarter"
In this very simple example there is no cash from this profit. The cash will come to you over five years. So you have to borrow to pay the dividend and the bonus and all the other current expenses relating to this profit.
What you have done is 'borrow' retained earnings from future cash flow. You look like you have retained earnings to support your tier one capital ratios. But when there is a real 'cash call' on your equity (2008) you do not have the cash equity to survive. So you have a TARP party.
The OTC reform proposal plan does not give the banks the ability to do this. And that is why they do not like it. This same income recognition issue exists in the OTC swap market for currencies with maturities greater than one year.
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To continue the discussion on OTC derivatives and zombie banks, we next feature an interview with Professor Ed Kane, James F. Cleary Professor in Finance, Boston College. Ed is a member of the Shadow Financial Regulatory Committee and one of the leaders of the US academic community when it comes to financial regulation. We spoke to him from his office in Boston.
The IRA: Dr. Kane, thank you for taking the time to speak with us before you leave on your trip to Europe.
Kane: Please call me Ed.
The IRA: Being a product of parochial schools, including a military high school, we tend to call everyone "sir" by default.
Kane: I went to a military high school too, St John's. I call it actually a quasi-military high school.
The IRA: St John's College High School In Washington? So did [IRA co-founder Chris Whalen]. Small world.
Kane: That's fantastic. I never thought of it as a completely military school. My father had been a cavalry officer in the US Army for part of his career before he was transferred to the Air Force in WW II, so I knew plenty about military discipline before I went to SJC. They really were not that serious about military discipline.
The IRA: We had the same impression. Were you also considered a trouble-maker for asking too many questions? [Whalen] was busted from his rank as Quartermaster Sgt of the Ranger Battalion to private in his senior year for pointing on the daily hypocrisy of the way in which the student officers behaved. Former Treasury Under Secretary for Domestic Finance and Assistant Secretary for Financial Markets Brian Roseboro was in that same class.
Kane: Yes. They would not even make me an officer. I made a lot of trouble. We had a West Point graduate as the senior military man at the school who was actually too militaristic to be promoted above colonel. I really enjoyed harassing him. Maybe that's where you and I get our righteousness, from our willingness to challenge authority.
The IRA: I think that is right. Independence of mind and the courage to challenge those in power is something we see less and less in our society.
Kane: Agreed. The real question is where do you get the stones to be confident in yourself. Military schools help in that they either make you or break you. Some people just fold…
The IRA: And some of us learn to ask questions. The Christian Brothers were always suspicious of [Whalen] for just that reason. The other kids in the class would copy down every word the teacher said and then regurgitate it verbatim at exam time.
Kane: Let me tell you a funny story. One Friday, the colonel came into our class at St John's and announced that we were behaving very badly and that, for punishment, we had to square all of the numbers from 1-200 and turn the results in on Monday. So I quickly figured out that (X+1) squared was a useful formula that let me just write down the answers. When I handed it in, the colonel said "you can't do it that way. This is unacceptable." And I replied "No it isn't. You told us to square the numbers. You didn't tell us to do it stupidly."
The IRA: Ha. So we understand from Josh Rosner that you had some very good comments about the proposals to reform the market for credit default swaps (click here to download Dr. Kane's presentation).
Kane: You folks at IRA have distinguished yourselves by your comments on this subject. I've been hearing a lot from Walker Todd about your work.
The IRA: Thank you. We'll be joining Walker and his colleagues at American Institute for Economic Research on June 25, 2009, for an event to discuss reform of the CDS markets. Of note, IRA is expanding into foreclosed asset management, recovery and disposition. In the months ahead, we hope to become an even larger part of the solution to the current crisis. You mentioned that you are going to be visiting Turin as part of your upcoming trip. No doubt you savor the irony of the two weak men of the auto industry, Chrysler and Fiat, being pushed together by the politicians in the respective countries.
Kane: Well, it makes sense. That is what governments typically do, put weak firms together and then do that again and again until the whole thing crashes.
The IRA: Let's start at the beginning with a discussion of the banking industry a year into the crisis and your presentation at the FRB Atlanta. The list of troubled institutions in The IRA Bank Monitor is now over 1,000 banks as of Q1 2009. What is your take as to the roots of this mess?
Kane: I focus on the role of safety net subsidies. The large firms understand this and have deliberately made themselves too difficult to unwind. The term "too big to fail" or TBTF misses the point. It is the difficulty of unwinding that is critical. There is a lot of discussion about the politics of TBTF, but it is also a cost-benefit analysis within the regulatory agencies that drives the decision. Look at how difficult it was for the FDIC to take over and unwind IndyMac Bank.
The IRA: A relatively small institution.
Kane: Yes, but the biggest that the FDIC had taken over and run to date. That is important. The FDIC saw that they could unwind a complex institution. They put one of their top people, John Bovenzi, and several other senior people in charge of the bank.
The IRA: For our readers, John F. Bovenzi was Deputy to the Chairman and Chief Operating Officer of the FDIC. When the Corporation takes over a bank, the COO becomes the chief executive. We suspect his colleagues will be running a few more banks before long.
Kane: Agreed. But to the point about politics, I believe it is a mistake to blame the reluctance to resolve complex banks only on political pressure. The other mistake that I constantly hear people make is that the industry puts pressure on the agencies, but the Congress stands up for the taxpayers. Actually the pressure goes through the Congress onto the agencies and nobody protects the taxpayer.
The IRA: Our nation's Founders worried about the development of factionalism based on geography, but instead we now have industry factions, the triumph of the corporate state. Members of Congress are bought and sold the way they have always been, just today it is corporations calling the shots instead of the Robber Barons.
Kane: No, they are rented.
The IRA: Speaking of rented representatives, we hear that many of the members of SIFMA cut their dues due to the economic meltdown, but JPMorgan (NYSE:JPM) reportedly doubled their annual contribution to $4 million and as a result Jaime Dimon got to pick the top two officials. This goes along with the massive lobbying firepower amassed by JPM is the past few months, including many of the lobbyists formerly employed by Fannie Mae and Freddie Mac. Since JPM is now a GSE, that seems appropriate.
Kane: JPM is the clear survivor and the vacuum cleaner that can pick up the pieces that have to be taken over.
The IRA: Indeed. Many of our clients believe that JPM is the last redoubt for both cash and collateral. We remind them, however, that all of the bailouts to date engineered by Treasury Secretary Tim Geithner and Fed Chairman Ben Bernanke, including the merger of Bear Stearns, the acquisition of WaMu and the rescue of American International Group (NYSE:AIG) were designed to prevent the trigger of CDS and the resultant evaporation of JPM. The bank is an afterthought compared to the OTC derivatives exchange that JPM has become. That is why JPM must ensure that any true reform of CDS is strangled with the proverbial umbilical cord.
Kane: Well sure, that was the point of my presentation last week at the Atlanta Fed. The way in which the CDS market has developed is a function of the dealers being "Too Difficult to Fail and Unwind" or TDFU institutions. Safety net subsidies keep other firms from gaining much market share.
The IRA: Precisely. So what is your take on the likelihood of reform in terms of CDS? We are participating in a panel discussion on June 10, 2009 sponsored by Professional Risk Managers International Association on June 10th in Washington to examine this very point. We have an excellent panel, including a late addition of former JPM official Tim Ryan, now President of SIFMA. He was registered as an attendee, so the moderator Gary Kopff of Everest Management invited him to join the fun.
Kane: The discussion seems to be coalescing around not a clearing house arrangement but a clearing platform. Such a platform provides some standardization and makes it easier to exit particular swaps positions instead of having to settle them with the original counterparty. This may, for example, give parties the ability to net-out opposing contracts that are bought and sold via different counterparties. I think this is something that people are willing to work towards. But the big dealer banks that enjoy safety net subsidies do not want to see this market migrate to an exchange. And ICE Trust -- the CDS clearinghouse that the dealer banks are backing - is a limited liability corporation. Unless we put the dealers on a partnership exchange, we won't really get the kind of tough monitoring and discipline of brokers and traders we could get with a partnership exchange.
The IRA: Yes. In an exchange model, the dealers are all joint and severally liable for all trades, so they must work to limit risk. In the OTC model, the incentives are just the opposite. The dealer banks still hold all of the collateral and, as we wrote in our comment two weeks ago under the Geithner plan the non-bank players, no matter how large or substantial they may be, are made second class citizens in a market they helped to create! Firms like Exxon-Mobil (NYSE:XON) and Royal Dutch Shell are far more sound financially than dealers like JPM, yet they must subordinate their interests to those of the dealer banks in order to participate in the OTC markets. In an exchange, all participants would be equal and the impartial third party - the exchange -- holds the money.
Kane: Yes, but remember that the exchange itself then becomes TDFU. An LLC uses only a dedicated and finite fund to bond traders against failures to deliver. Once that fund is exhausted, authorities will be under pressure to come up with a rescue plan. What benchmark do they have to step in and limit losses in such a scenario? The AIG case tells us that the plan will be to throw taxpayer money into the pot.
The IRA: Indeed. So throw money is the default plan in the event of a systemic failure. But we keep wondering what happens when we find the next dumbest guy in the room after AIG, to paraphrase Martin Mayer, and the system requires yet another mega bailout. If there is another default event of the magnitude of AIG, would this provide the political catalyst for more change, perhaps all the way to an exchange model? As we already noted, the Geithner plan marginalizes all of the non-banks corporates, funds and other players in the OTC derivatives markets in favor of the banks. There is a growing awareness of this fact and it may just take another default event to swing the political equation against JPM and the other dealers, who keep claiming that there is nothing wrong with the current OTC model.
Kane: It tells you where Geithner sees the benefits to his policy making.
The IRA: At the top of this issue of The IRA, we feature a comment from a read named Bruce Rating, who makes the point that the banks base reported earnings and executive compensation on the assumed profits of structured finance and OTC derivative deals that pay over a period of years, thus the bank has to borrow money today to pay dividends and compensation that is not yet supported with cash received.
Kane: One of the things I have suggested in some of my writing is that we should pay executive compensation in the same instrument that generates the banks income. That way the executive is taking the same risk as the organization and its clients. Society must find ways to lengthen the horizon of organizations and managers, if we are to fix the unhealthy incentives at work in financial institutions today.
The IRA: To shift to the condition of the large banks as we go through 2009 and into next year, the changing investor tone in the bond market seems to suggest that it is going to be very hard for the banks and even the US Treasury to support a large portion of liabilities via the issuance of long maturity debt. Asian investors are turning up their noses at Treasury debt with maturities longer than five years and this change will also impact the funding costs for the zombie banks, which now depend upon government guarantees to issue debt. What happens to the large banks and the subsidy arrangement you've described if they are all forced down the curve in a rising rate environment. The assumption inside Treasury and the Fed of New York is that the dealers will be able to rebuild their market access with non-guaranteed debt at gradually falling spreads, but long-dated Treasury paper may widen so much that any improvements in the investor acceptance of bank paper is muted. How do you see the banks operating in an environment where global investors are backing away from sovereign risk?
Kane: There are so many things to say about this. As long as the authorities are willing to pump money into zombie firms, they are making bad bets. The incentives of the zombie firms, especially those with stock-based formulas for executive compensation, is to take longshot gambles even if the investments have negative present value. So-called toxic assets are precisely the type of exposures managers want to keep when their enterprise has no economic net worth and all of their resources are coming from the public safety net. Once the economy gets better, some of these assets will gain value sharply. Putting money into the zombie institutions is likely to make things worse in the long run unless the country is very, very lucky. It is not a good bet. One can win some bad bets, but in the long run the strategy is a loser. A bad bet makes sense for zombie managers, but not good bets for the country. The whole basis of policy making in Washington today is that the taxpayer is a sucker who does not know how to defend him or her self against this kind of regulatory gambling. The sucker never gets an even break.
The IRA: Well you saw that the FDIC is imposing limits on the interest rates that troubled banks may offer on deposits. Wonder if they will apply those rules to Ally (f/n/a GMAC Bank)?
Kane: Well, again, one of the problems is that the authority to regulate bank holding companies resides with the Fed. The Fed has been captured by the financial sector. As I see it, the central bank is destroying its credibility. Many Reserve Bank presidents understand this and have been fighting for better policy within the FOMC, but that isn't where supervisory decisions are made. The result is that some Reserve Bank presidents are very frustrated.
The IRA: Well, the talk in town is that there is open warfare between the Fed Board in Washington and the Federal Reserve Bank of New York, due partly to the latter's alignment with the Geithner Treasury. We have a former economist from Goldman Sachs (NYSE:GS) in Bill Dudley running the FRBNY and so that "capture" by GS, JPM, etc. is complete. And it looks like the Board is now regaining courage, refusing to allow the TBFU banks repay their TARP funds unless they raise a certain about of equity. The FRBNY is entirely captive of JPM and GS, in our view.
Kane: Well, the way I look at it is that the Board and the Reserve Bank presidents have a long-run interest in maintaining their credibility and independence. Treasury Secretaries come and go every few years, but the Fed's leaders have much longer tenures. They are supposed to use the protection of their tenure to ensure independence in decision making. Federal Reserve Bank presidents should be concerned with the impact their policies have on "the firm." To greatly simplify the example, the Fed is going to face scathing criticism going forward. It is going to be blamed for many of the failings of current policy long after Secretary Geithner is gone. I have written a lot about this over the years. I see the role of the Fed is to be the scapegoat for the bad decisions made during this period. The Federal Reserve is purported to be an agency that can and will take a longer view.
The IRA: Well, a case in point is the approval of the bank holding company application by GMAC. That approval is an outrage, but neither the Reserve Bank nor Bernanke and the rest of the Board had the courage to say no to the White House. Now we have a bank holding company that is insolvent and is literally being kept afloat with subsidies from Washington while its bank unit, Ally, advertises for deposits on national TV, radio and other media in competition with solvent banks. In our view, the right thing for Bernanke to have done was to say no to the application and force the Treasury, which was then under former GS CEO Hank Paulson, to seek legislation to bail out the non-bank financing arm of GM. But neither Bernanke nor the other governors seem to have any spine whatsoever. That was a terrible day for the Fed as an institution. And the Board continues to approve applications that slam zombie banks together, even though these combinations are never successful. The banks get bigger and require bigger implicit and/or explicit subsidies.
Kane: In my view, the Board does not adequately understand the incentives of zombie banks. If the Fed and the Congress appreciated the incentives of zombie firms, they would not be playing around the margins with executive compensation. They would be actively limiting risk taking by these firms. That is why we had a deepening crisis, at least until the results of the stress tests began to be leaked. It looked as if the authorities did not have a clue. The first crisis managers must do is triage. By doing that - or at least appearing to do that - authorities temporarily stabilized expectations. Now they've got to follow that triage up with appropriate action, but proposals like PPIP are just terrible.
The IRA: Only the zombies want to attend the party. None of our clients are participating. The chief reason is fear of sovereign risk in terms of dealing with the US Treasury. They look at the Congress and the Geithner Treasury. Investors see the instability and inconsistency of the thinking in these captive institutions and the reaction is negative. Then investors look at the behavior of the Obama Administration vis-à-vis private investors in the Chrysler and GM situations and that ends the discussion. By crudely threatening investors in Chrysler and GM, President Obama and aides like Steve Rattner are burning bridges with investors that we as a nation will need later this year and beyond. Only players who are already in bed with Treasury could find "opportunities" such as PPIP and TALF attractive. To get back to the zombie issue, is there any hope that we will see meaningful restructuring of the larger banks?
Kane: Oh yes, eventually. You can't run this game forever. The credit rating organizations - I refuse to call them "agencies" - came close to lowering the rating on New Zealand the other day…
The IRA: The UK is also now on a "credit watch" by one of the ratings monopolies. Incidentally, we understand that the Obama Department of Justice is considering anti-trust action against several of the ratings monopolies as part of the Obama witch hunt against corporate America. This sort of behavior explains why few investors want to do business with the US government when it comes to toxic assets or anything else.
Kane: Well, once the credit ratings are lowered on a few sovereign names, then the question of the condition of Treasury and Fed balance sheets will come under analysis. There is going to be pressure on Treasury yields as you mentioned. We will see competition from other sources.
The IRA: So perhaps the view of the late Milton Friedman that we could exchange pieces of paper for real goods with our trading partners indefinitely was a little too glib?
Kane: It is. It has always been glib to say that Treasury debt is risk free. It has always carried inflation risk. A country can inflate its way out of debt, but it is effectively a partial default on the debt holders.
The IRA: We've actually heard some members of the far-left wing of the Obama Nation advocating the idea of calling in all outstanding Treasury debt and issuing enough fiat paper dollars to redeem it all at par. That is the kind of thinking that was seen in Weimar Germany and also in Latin America during the debt crisis. They seem to think that dollars and US Treasury debt are interchangeable.
Kane: What has been most distressing about this episode of crisis management is that our country has done precisely what we have always told other nations not to do. I hope that President Obama understands that following these short-sighted polices at the beginning of his term is going to result in some very serious problems next year in the mid-term election and in 2012 when he stands for re-election.
The IRA: If President Obama stands for re-election. Thanks Ed.
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