April 2010 Archives

As Greece gets ready to default or restructure its debt, and several other Eurozone countries deal with their rating downgrades, it is useful to keep things in perspective. Here are ten interesting facts based on reports from IMF, Morgan Stanley, Citigroup and my ongoing research with colleagues Itamar Drechsler and Philipp Schnabl ("A Pyrrhic Victory? The Ultimate Cost of Bank Bailouts"):

1. Sovereign credit default swap and bond spreads started rising in the Fall of 2008,
especially following the collapse of the global financial system (failures of Lehman Brothers and A.I.G.).  

2. In most cases, the widening of sovereign spreads was initiated by announcement of massive rescue packages for the financial sector and in some cases equally large fiscal stimulus packages. For instance, the immediate cost of UK's rescue package was in excess of 20% of its GDP.

3. As sovereign spreads widened with announcement of rescue and stimulus packages, in the short run bank and financial firm spreads in fact fell. But within a few weeks of the announcement, both sovereign and financial sector spreads started moving in tandem. There was effectively a "merger", a transfer of the "bad bank" assets of the financial sector into the government. Or you could say, we passed on the buck to the governments!

4. But it is not all about the additional debt and risks taken on by governments through the rescue packages. Countries that have experienced the greatest widening of their spreads are those that have also had high levels of debt relative to GDP and relatively low levels of labor productivity and global competitiveness.

5. Most developed countries are now running debt to GDP levels in the range of 50-120%. Typical emerging market defaults on external debt have in fact been at lower debt to GDP levels of 40-80%. The financial crisis of 2007-09 is metamorphosing as a potential sovereign crisis of 2010. 

6. The US debt to GDP level is now at the same level as that after World War II. That should help put in perspective the crisis we have just witnessed (and the fiscal imprudence in the period leading up to it). 

7. With all this credit deterioration of sovereigns, the interest in their credit default swaps (CDS) - a way of buying protection against default on sovereign's debt - has increased dramatically. While there were hardly any trades happening in sovereign CDS prior to the crisis (and in fact, until Summer of 2008), these are among the most widely traded CDS now.

8. The financial sectors of various countries are buying massive protections against sovereign credit risk. Net dealer exposures to Western countries has been rising dramatically since the Fall of 2008. Gross exposures in SovX, the Eurozone CDS index, now exceed exposures to financial CDS. 

9. Since November 2009, the rapid widening of Eurozone sovereign CDS has been accompanied with little widening, if any, of global, investment grade corporations and financials of these countries. Now, it is the "bad countries" of the world that are partially getting merged with safer countries' balance-sheets (Think of Greece and Germany!).

10. The ratio of CDS traded to debt for sovereigns is the highest for Eurozone countries at the current moment, reflecting both their credit risk problems as well as their monetary inflexibility given the currency union. In contrast, CDS to debt ratios for the UK and the US are tiny.

Moral of the story: At least two.

1. Bailing out banks or countries does not mean the credit risk of their bad assets just vanishes in thin air. It simply gets transferred to (other) sovereign balance-sheets. But these sovereign balance-sheets, like corporations, also have limited debt capacity.

2. It may be time for most countries, including the United States, to exercise fiscal restraint and devise a clear strategy to reduce government debt over next 3-5 years. Those who do not act now put at risk any economic recovery witnessed since the Fall of 2008. Sometimes, less is more!

Do We Really Want to Protect Consumers?

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by Vicki Morwitz and Robert Whitelaw

This spring Senator Dodd unveiled a Senate bill claiming to place the protection of consumers at the top of the list. Consumers--homebuyers, taxpayers, the everyman investor--were the big losers in the greatest financial crisis in recent history. Now, with a bill moving swiftly, perhaps, through the Senate, victory may be at hand. Or is it?

The Riskiest Financial Firms In America

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by Thomas Cooley

New measurements identify the institutions that pose the greatest risk.

We are now well past the worst throes of the financial crisis. Banks and financial institutions are earning record profits. The economy is recovering steadily. All is right with the world! Wishful thinking. The uproar over the fraud charges against Goldman Sachs last week should have underscored that we still haven't addressed the underlying sources of the risk that caused our financial collapse in 2007-2009.

In the wake of the charges the value of Goldman's stock plummeted and brought the shares of other banks down with it. It was an ominous sign that the markets realize there is still plenty of systemic risk in our banking system.

A group of my colleagues at the NYU Stern School of Business have been working since the beginning of the crisis to figure out how we can measure the risk that firms pose for the financial system as a whole. There are two parts to the risk that firms carry: 1) the risk they impose for their own shareholders because of the strategies they use to earn profits; and 2) the risk they create that spills over to the system as a whole if they get into trouble. We now have measures of that risk. The measures are updated weekly and viewable online.

Read the full opinion editorial at Forbes.com.

Financial Reform's 'Public Option'

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by Thomas Cooley

How President Obama's consumer-protection plan threatens his plan to rein in Wall Street excess.

In the early proposals from the Senate Banking Committee, the creation of an independent Consumer Financial Protection Agency (CFPA) was a centerpiece of the proposed Restoring American Financial Stability Act.  The CFPA has drawn such fierce opposition that it is threatening to become like the public option was for health-care reform, a lightening rod for competing views about the proper role of government and a distraction to practical law-making. The media attention and financial-market reaction to the accusations that Goldman Sachs deceived investors about the nature of the synthetic collateralized debt obligations (CDOs) make one thing very clear: we need more transparency in financial markets. We have to get financial reform right so we mitigate the risk of future meltdowns of the system. The outrage over this case seemingly strengthens the hand of the Obama administration in getting the legislation it wants. In his speech to Wall Street on Thursday, President Obama stated, "It is essential that we learn the lessons of this crisis so we don't doom ourselves to repeat it. And make no mistake, that is exactly what will happen if we allow this moment to pass--an outcome that is unacceptable to me and to the American people." Fair enough. But it is surprising that they have courted failure by lumping regulatory reform together with consumer protection.

Read the full opinion editorial at Newsweek.com.

Why Financial Reform May Just Work

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by Matthew Richardson and Nouriel Roubini

The economy is in ruins. Unemployment is at levels not seen in decades. The public seethes. Congressional hearings call for the heads of bankers. Bankers lobby behind the scenes. Politicians fight over the seeming minutiae of regulatory reform.

The year might sound like 2010, but it was actually 1933.

As President Obama visits the city that was at the core of the crisis - and the city that is key to our revival - history can teach us a valuable lesson. Namely: In the wake of a massive shock to the system, stronger rules of the road for large institutions are a prerequisite for sustained recovery.

Read the full opinion editorial at NYDailyNews.com

Banks Have Way to Help Themselves

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by Yakov Amihud and Ingo Walter

During the recent credit crisis, U.S. banks in urgent need of capital quickly received
bailout funds from a government fearful of a systemic collapse.

As a way of avoiding the next financial debacle and the consequent socialization of losses, banks should be required to avoid becoming undercapitalized in the first place.

Before providing banks with public funds and putting the taxpayer at risk, the government should require that troubled lenders help themselves by raising capital from their own stockholders through coercive rights.

Read the full opinion editorial at Bloomberg.com.

Money Funds Too Big to Be Ignored

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by Marcin Kacperczyk and Philipp Schnabl

Money market funds are the stepchildren of finance. Though they manage more than $4 trillion in assets, they have not gotten much attention recently. Sen. Chris Dodd's regulatory reform proposal does not even mention money market funds. Is the omission justified?

If you analyzed the track record of money market funds up to 2007, you would think that Sen. Dodd is right. Money market funds are simple structures; some may even call them boring. They collect deposits and invest them in (almost) riskless money market instruments. In doing so, they earn a small yield while making sure the fund does not lose any money or, in Wall Street parlance, "never breaks the buck." For this reason, many investors think of money market deposits as the big brother to bank deposits. The only difference between the two is that money market deposits have no Federal Deposit Insurance Corp. guarantee.

However, if you analyze the performance of money market funds during the financial crisis, you would find that their omission from the Senate legislation is a glaring mistake.

Read our full opinion editorial at American Banker (subscription required)

by Thomas F. Cooley

The Dodd bill makes some important improvements to corporate governance.

Since the onset of the financial crisis there has been a huge hue and cry about executive compensation, particularly compensation on Wall Street. It isn't hard to understand why, and it would not have been unexpected to see financial reform legislation that took a heavy-handed approach to "reforming" compensation practices. Early on in the crisis there were proposals to impose an 80% tax on bonuses and proposals to cap compensation in absolute terms. Last week members of the Angelides commission, charged with investigating the causes of the financial crisis, pummeled former Citi executives Charles Prince and Robert Rubin for getting generous compensation while the firm essentially collapsed around them.

We saw much of the same reaction in the 1930s. There was a huge public outcry over the compensation of Eugene Grace, the president of Bethlehem Steel ( BHMMQ.OB - news - people ), when it was revealed that he received a base salary of $12,000 and a bonus of more than $1.6 million in 1929. That amounts to $150,000 salary in 2010 dollars with a nearly $20 million bonus.

In spite of periodic expressions of outrage, efforts to "reign in" executive compensation have so far been relatively muted. The major pending legislation--Sen. Dodd's "Restoring American Financial Stability Act of 2009"--makes some very cautious but important recommendations about compensation. There are four that are notable.

Read the full opinion editorial at Forbes.com

End users such as Lufthansa, Rolls Royce, Caterpillar and the like are being offered exemption from clearing requirements that dealers are likely to face in OTC derivatives. The European regulators appear to be moving in this direction, but only subject to some important checks: audit/accounting reports to detect end users are hedging or speculating, or restrictions on size of transactions.

See the FT article.

These checks to ensure that OTC end-user exemption is not abused mirror closely the proposals made by the Stern Working Group on the financial crisis in their assessment of the end-user exemption in discussion of House and Senate Bills: http://govtpolicyrecs.stern.nyu.edu/docs/whitepapers_ebook_chapter_16.pdf

by Matthew Richardson and Nouriel Roubini

Between the fall of 2008 and the winter of 2009, the world's economy and financial markets fell off a cliff. Stock markets in the United States, Asia, Europe and Latin America lost between a third and half of their value; international trade declined by a whopping 12 percent; and the size of the global economy contracted for the first time in decades.

When economists and Wall Street types toss around the term "systemic risk," that's pretty much what they're talking about. The particular risks that led to the crisis -- i.e., big institutions with too much leverage, too little capital and too many implicit and explicit government guarantees -- were not impossible to anticipate. (In fact, some of us warned about the financial pandemic that was to come.) Now, the question is: How do we keep this all from happening again?

To create a truly safe financial system, we have to focus on two goals. First, we have to drive a stake through the heart of the "too big to fail" mantra that only fattens our financial beasts. Second, we should stop focusing on the problems of individual banks and look at the broader risk that the largest and most complex financial institutions pose.

For the full opinion editorial in Sunday's April 11th Washington Post, please go to the following link





Some Contingencies for Contingent Capital

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A number of academics and policy makers have favored the forced debt-for-equity conversion bonds or contingent capital. With any regulation, the key is to know strengths and weaknesses. The strengths of contingent capital have been mentioned a number of times here and there (for most recent FT article, see http://www.ft.com/cms/s/0/0310ebf4-4342-11df-9046-00144feab49a.html). Here, I outline some contingencies for contingent capital that regulators must keep in mind.

Prisoners of Our Own Device

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by Barry Adler

The Dodd bill, just released by the Senate Banking Committee, would impose extensive new restrictions on the provision of financial services in the United States. These restrictions represent a fair price to pay for institutions that desire government backing, but they may prove insufficiently effective and unnecessarily stifling to companies that would prefer to go without government support.

To illustrate this point, consider what has come to be known as the Hotel California Provision, under which bank holding companies that have received TARP funds would be unable to avoid Federal Reserve supervision even if they eliminated their banks.  In the words of the iconic pop lyrics: "You can check out any time you like, but you can never leave."

In an April 7th, Wall Street Journal Opinion piece, authors Peter Wallison and David Skeel argue that the current version of the Senate bill should be opposed because "the simplest and clearest (reason) is that the FDIC is completely unequipped by experience to handle the failure of a giant nonbank financial institution." (see the full article in the Wall Street Journal.)

When Congress returns next week, financial reform will finally headline the agenda.

Taxpayers have been laden with huge debt burdens to rescue the banks and protect the soundness of the financial system. Wall Street banks have lately enjoyed improved earnings and big share gains. But the causes of the credit meltdown have still not been addressed.

The bill from Senate Banking Committee Chairman Christopher Dodd, D-Conn., offers more than 1,300 pages worth of fixes. But length and complexity do not ensure effectiveness.

Derivatives, bank capital and leverage rules, and asset securitization were three root causes of the crisis. Several experts, including Matthew Richardson, professor of finance at the NYU Stern School of Business, question whether the Dodd bill would deal with these issues effectively enough to avert another costly crisis.

Read the full article from Investor's Business Daily with Richardson's comments.
by Viral Acharya and Marti Subrahmanyam

A key aspect of the bill on Restoring American Financial Stability proposed by the Senate Banking Committee under Senator Christopher Dodd is the sweeping reform of the derivatives markets targeted at improving their transparency and accountability. The bill aims to "eliminate loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter (OTC) derivatives." 

by Edward I. Altman, Sabri Oncu, Anjolein Schmeits, and Lawrence J. White

The three large global credit rating agencies - Moody's, Standard & Poor's, and Fitch - were central players in the subprime residential mortgage debacle of 2007-2008. Their initial overly optimistic ratings on mortgage-related securities encouraged the housing boom and bubble of 1998-2006. When house prices ceased rising and began to fall, mortgage default rates rose sharply, and the prices of the mortgage bonds cratered (as did their ratings), wreaking havoc throughout the U.S. financial system.

The Securities and Exchange Commission has already expanded its regulation of the rating agencies, and congressional legislation may well insist on more. But to understand the proper route forward, it's important to understand how we got to where we are today.

by Stijn Van Nieuwerburgh and Lawrence J. White

The financial regulatory reform bill that was recently proposed by Senate Banking Committee Christopher Dodd has a huge hole: It says nothing - absolutely nothing! - about Fannie Mae and Freddie Mac. These are the two investor-owned government-sponsored enterprises (GSEs) that currently are at the center of the residential mortgage markets in the United States. They are the two 900-pound (or $900-billion-in-assets) gorillas in the room that keep getting ignored.

The Fallacy of Bank Diversification

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by Viral Acharya & Matthew Richardson

In a recent Wall Street Journal article, John Varley, Barclays Chief Executive, was quoted as saying: "We see big banks as diversifiers, not risk aggregators." His comments are part of a chorus of Bank CEOs now questioning various reforms that are aimed at large, complex banks.

He is plain wrong and regulators should be wary of such arguments.

Financial Reform and the Fed

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by Kermit Schoenholtz and Paul Wachtel

The Federal Reserve in 2008 and 2009 took many unprecedented actions that helped halt the worst financial crisis since the 1930s. Yet never has the Fed provoked as much scorn and resentment as it did when it bailed out the creditors of Bear Stearns and AIG. The resulting wave of dissatisfaction fostered the greatest effort to weaken the Fed since its establishment nearly a century ago.

For our full op-ed on Forbes.com, go to http://www.forbes.com/2010/04/01/federal-reserve-independence-financial-crisis-opinions-contributors-paul-wachtel-kermit-schoenholtz.html

About RegulatingWallStreet.com

The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors