Nowhere to run to, baby.
Nowhere to hide.
- Martha and the Vandellas
Martin Lowy in his recent article, " Bank Bondholders Get Better Protection," has substantially added to the information content of the ongoing discussion in SA of the way the next banking crisis will unfold.
He based much of his discussion on a detailed slide deck provided by Davis Polk, to be found here. This slide deck is an excellent summary of the Fed's newest effort to slow the out-of-control-freight-train that might well blow the entire financial system to smithereens in the next crisis. Davis Polk calls it the "Lehman phenomenon." This phenomenon we will describe in a moment. If you want to know all about this Fed initiative, the Davis Polk deck is the place to go. Also if you're having trouble dropping off to sleep some night. 75 slides.
This article falls as well within the topic of some of my most recent posts, discussing the many ways in which OTC derivatives have become dysfunctional, " The Many Points Of Failure In The OTC Derivatives Markets," and " Magic Money: The Second Point Of Failure In The OTC Interest Rate Swaps Market."
Please don't miss Jason Cawley's partial rejoinder to Lowy's somewhat optimistic take on the implications of the Fed and ISDA's initiatives to make the world a better place for bank debt-holders. Cawley's comments are found in response to Lowy's article. Cawley makes very telling points. Among them:
- In the past the locus of failure has always been outside the derivatives book
- So what if bank debt becomes safer? The Fed can only make bank debt less risky by making some other security (or obligation, such as your tax bill) riskier. (My note: True, but not the whole story. The issue I consider is whether or not debtholders are aware of the threat posed by seizure of derivatives collateral.)
- The Fed relies for its solution to the Lehman Problem on a mystical "third party," that will assume the obligations of a failing dealer. Cawley wonders, "What third party?" Good question. I have a possible answer.
Making the world a better place for debt-holders has merit, since as I and others have pointed out, many recent financial market developments are making the world more hazardous for bank debt-holders. And what disturbs me most about the factors making the world dangerous for bank debt-holders is this. Nobody is telling the debt-holders. If you are a bank debtholder, read Lowy's article. Believe me, you have things to worry about, as Lowy explains.
Let me summarize my personal take on Lowy's article and the supporting Davis Polk document, along with Cawley's remarks.
- Derivatives won't start the next financial crisis. Unless it's some large dealer bank [In the US, according to the Office of the Comptroller of the Currency (NASDAQ:OCC), that's Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JP Morgan Chase (NYSE:JPM)]; that is completely outside the regulatory umbrella and its derivatives dealers are totally beyond management control. Like Deutsche Bank (NYSE:DB). Now.
- The real crime in the derivatives market is Congress' many changes in the bankruptcy code. Lowy has an overly charitable take on the genesis of the Lehman Problem. In his words, "The financial community broadly saw that result [the beggaring of Lehman's debtholders] as inappropriate [after Lehman]." (my insertions) This is simply an overly charitable description of the financial community's (or at least derivatives dealers') knowledge of the effects of changes in the bankruptcy code before the Lehman debacle. I attended early meetings discussing to need to push for the change in the code. There was plainly an understanding that there were only days between a derivatives fail and financial Armageddon unless there was a stay in the bankruptcy code. Since, of course, nobody could be expected to either curtail or alter their derivatives strategies, the code had to change. Everybody in these meetings understood whose ox was getting gored. Informed banking executives were not taken by surprise by the seizure of collateral in the Lehman bankruptcy. It is a bank exectutive's responsibility to know the bankruptcy code. The debt and equity holders of financial institutions, and taxpayers, on the other hand, did have a new understanding of derivatives. And that is what is moving ISDA and the Fed to action.
- What of the Fed's mystical transferee and its motives? In Cawley's words: "In other words, as long as someone with the means to do so, very promptly offers to continue paying as contracted... Of course, the protection of collateral agreements for derivatives contracts is needed precisely when and if there is no such successor. The Fed and industry contract standard form have a touching, pious hope that there will be such a successor, always. But why do they think so?" I agree with Cawley. There will be no such willing transferee. For reasons, enumerated in my recent articles I cite above, I would not touch any dealer's existing derivatives commitments with a ten-foot pole.
Here's what I think is actually going on. There is a well-developed plan - not the one the ISDA provides the public; not the one the Fed provides the public. In the event of the merest threat to the liquidity of a derivatives dealer, the Fed is going to have employees swarming that dealer's trading room. If they even smell illiquidity, "third parties" - the other dealers - will be impressed into duty, and the short-term liquidity needs of the sweating dealer will be met.
If the bank is in the US, the Fed will kind of wave its hand at the one-day stay Lowy is describing. Whether the regulation has been passed yet or not, the fix is in now. There will be no run on the weakened bank's collateral. The Fed realizes nobody may be allowed to blow up the problem bank's collateral as was done to Lehman. There will be no feeding frenzy in the exchange clearing houses, either. The dealers will all be kept afloat in the near term.
This will give the FDIC time to decide whether a resolution is called for because a bank is really not solvent; or whether loans should be made to the banks, because the banks are all still solvent and the system must be saved. The lending authority is there now, after a fashion. And in what past crisis has law denying the government permission to rescue the financial system ever been enforced, with the disastrous exception of Lehman?
Don't let a big bank die suddenly. If it's truly insolvent, let it fade away after an FDIC evaluation. That's the lesson of Lehman.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.