domingo, 14 de febrero de 2016

domingo, febrero 14, 2016

When The Next Too-Big-To-Fail Bank Fails

by: Kurt Dew


Runs on banks and financial institutions, historically, are a fact if life in the banking business.

The exemption of banks' derivatives positions from bankruptcy protection, along with the mandate to clear derivatives, puts dealer banks in greater danger.

Derivatives clearing houses apparently consumed three times the face value of Lehman's equity in four days' time.

The Orderly Liquidation Authority, a sheep in wolf's clothing, will protect the next bank facing this threat.
 
First, I think it is axiomatic that there will be another Big Bank "episode." However, the purpose of this article is to suggest that the horrors of this event are exaggerated in the minds of investors. So my point is this: Yes, there will be another "crisis." But the process of resolving the problem is not going to be as nasty as some might think.
 
Close observers of the Lehman Brothers bankruptcy may have concluded otherwise. I rebut this view.
 
I believe the fears of crisis-induced dealer-bank insolvency are part of the puzzle of the anemic market valuation of these banks. While there are other reasons for these weak valuations that I accept - such as the European dealers' [Barclays (NYSE: BCS) Credit Suisse (NYSE: CS), Deutsche Bank (NYSE: DB) and UBS (NYSE: UBS)] current desperate dash for the exit door of the dealer community - I believe the valuation of dealers like Bank of America (NYSE: BAC), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), and JPMorgan Chase (NYSE: JPM) are being unfairly penalized by fear of a TBTF collapse.
 
The reason there will be another episode is that history promises it. There have always been bank "episodes." They occur regularly everywhere on the globe where banks are in competition. (But not, for example, from 1945-1970 in the US, when banks were not permitted to compete. Or in Europe where failing banks become wards of the state.)
 
Episodes are in the genes of financial institutions when they compete. Yes, Dodd Frank makes TBTF "illegal." But the government has outlawed TBTF at least three times so far. The effect of the first two prohibitions have been nil. Once after the Continental Bank Crisis, once after Long Term Capital, and once after Lehman Brothers. Although these episodes are inevitably linked in our minds, they were very different. That's why I use the word "episode," rather than failure or bankruptcy.

I take the planned concerted attempt by the federal government to punish the debt- and equity-holders in the next bank failure seriously. There is no longer support within the ranks of government for a multi-billion-dollar bailout under any circumstances. But that bailout can be avoided (barely, with the current fragile OTC market structure) and there is a reasonable plan to prevent TBTF banks from endangering the system.
 
It is clear at the moment that our dealer banks are solvent. In other words, given the time, the large US dealer banks would easily pay off their debts if forced to do so today.
 
The problem is, in crises, a bank is never given time. And very few financial institutions, least of all banks, can liquidate in a matter of days. This fact is the reason episodes are inevitable.
 
When investing in financials, such crises must be considered straight on. It is pointless to go into denial. But expecting such things is, I emphasize, not inconsistent with the purchase of banks' common stock. But in doing so, an investor should consider how the crisis event will play out.
 
In the current environment, which needs changing desperately, it is crucial to understand, on a day-by-day basis, what the likely chain of events will be. The possibilities today are the result of the government's learning experience with past episodes - most recently, and importantly, the Lehman Brothers bankruptcy. There were four interesting aspects of that episode.
  1. Lehman Brothers had done exactly zero planning about the effects of bankruptcy on the company. They concluded from the Bear Stearns rescue that bankruptcy was off the table.
  2. The filing of bankruptcy was the direct result of a very strong rumor that the regulators would not step in.
  3. The derivatives positions of Lehman Brothers, an obvious potential source of problems, split neatly into two pieces: a.) the cleared derivatives, which were terminated and transferred within four days of Lehman's declaration of bankruptcy, and b.) the bilateral derivatives positions, many of which remain unresolved today.
  4. The cleared derivatives positions, and their handling by derivatives clearing houses, are the issue that distinguished the Lehman bankruptcy from the earlier experiences. The exchanges, unleashed from any concern for a court defense of Lehman's estate by their exemption from the bankruptcy law, went into an unprecedented instant feeding frenzy, consuming vast amounts of Lehman's marketable assets in a four-day span.
 
So what was learned from the Lehman episode? Three lessons became part of Dodd Frank.
  1. Require the banks to develop a detailed plan of how bankruptcy, and economic crises generally, will be managed.
  2. Reduce the reliance of the large banks on repo funding and tighten the quality of repo collateral.
  3. For bilateral (uncleared) derivatives positions, require much more collateral.
 
None of these remedies is foolproof. But each makes sense and provides some degree of comfort that the next episode will go more smoothly.
 
But there is no discussion in Dodd Frank of the derivatives clearing house feeding frenzy, which by one authoritative estimate, consumed an amount equal to three times Lehman's equity in four days.
 
A fourth remedy of Dodd Frank is the one I believe will be the central focus of the next crisis.
 
Until Dodd Frank, the government had two options in a bank crisis. Go to FDIC resolution (bankruptcy by another name for banks) or bail out the firm. But Dodd Frank introduced a new alternative - the intervention of an Orderly Liquidation Authority (OLA).
 
The OLA will be at the heart of the resolution of the next crisis. What is it, and why is it important? My conclusion is that it is not what it claims to be. It is not, as the name suggests, simply an orderly way of disposing of assets in bankruptcy. In fact, it is a way of preventing the bankruptcy of solvent institutions.
 
 
The Orderly Liquidation Authority
OLA claims to be a way of "winding down" a failing Systemically Important Financial Institution (SIFI). SIFI is a euphemism for TBTF.
 
And the unspoken lesson of the Lehman Brothers bankruptcy is exactly that: If there is no OLA, a TBTF bank under pressure is blood in the water of the shark tank that is today's derivatives marketplace. No bank with position exposure in the multi-hundred-trillion-dollar neighborhood - a condition which describes any dealer bank - would be solvent following the clearing house feeding frenzy that consumed Lehman.
 
The congressional mandate of the OLA gives an idea of just what kind of pressure this TBTF institution is expected to experience. The OLA has exactly one business day to intervene before the shark attack begins. In other words, due to the excessive riskiness of the OTC derivatives instrument, the suspension of the bankruptcy law in the case of derivatives creates a situation where every dealer bank must be protected from the other dealer banks or face instant bankruptcy.
 
There was a time, not so long ago, when the bank clearing houses existed to provide their members support in cases of temporary insolvency - protecting solvent members from runs. Today, the clearing members wait for a sign of weakness from a member, then attack and destroy the weak before the courts can intervene.
 
The fate of Lehman showed this. As rumors of the Lehman bankruptcy began (days before the actual bankruptcy filing), the derivatives clearing houses that would be affected (for futures, CME Group (NASDAQ: CME); for OTC interest rate swaps LCH:Clearnet) knew it was coming. Both exchanges immediately moved to receive bids from other clearing members on Lehman's positions and margins. 
 
We know the details of the events that followed in the case of the CME, but not for LCH:Clearnet.
 
We know only that the Lehman positions were replaced without loss to clearing members at LCH:Clearnet.
 
At the CME, Lehman lost collateral worth about $3.3 billion in order to settle positions requiring $2 billion in margin funds within four days of filing for bankruptcy, thus costing the Lehman estate a net amount of about $1.3 billion.

In that same four-day interval, LCH:Clearnet closed out Lehman's positions and returned a substantial sum to the Lehman estate. How much of the Lehman estate's money was seized at LCH:Clearnet? Nobody seems to know. We have only the estimate of Bryan Marsal, the lawyer representing Lehman in liquidation. He estimates the estate lost between $50 and $75 billion.

This may be compared to Lehman's book equity at the time of roughly $25 billion. The moral of that story is that without protection, any derivatives dealer in crisis will be bankrupt before it sees the inside of a courtroom.
 
So into this rather bleak scenario, we insert the OLA. It will have available funds in the amount of 10% of the at-risk bank's assets. Would that be sufficient to assume the derivatives positions of the at-risk institution at a fair price? It is by no means clear that this would be the case, since the value of these positions is quite arbitrary in the case of positions as large as those of the dealer banks. But here is my thinking. Suppose the OLA simply takes ownership of the at-risk bank's positions and assumes its clearing membership as well.
 
There would then be a meeting of the clearing members to determine the status of these positions. I find it likely that other clearing members would be reluctant to assert the OLA was under-margined without lending the OLA collateral sufficient to come up to snuff. In other words, the OLA makes good shark repellent.
 
This, and the OLA's option to grant further credit to the at-risk institution later, will give the regulators sufficient time to resolve the episode in a way that best serves the interests of the system as a whole. If there are not sufficient assets to pay the liability-holders in the long run, so be it. That is a central intent of Dodd Frank. Neither stockholders nor debtholders should get free rides if the bank is actually insolvent.
 
But the dealers' newly discovered ability to cannibalize each other with OTC derivatives clearing houses must be stopped. And OLA has stopped it. But there are ways to reduce the clearing member exposure to something closer to the $3.5 billion that was Lehman's futures exposure at the CME. Why not do that?

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