Whirling Derivative Dervishes: Treasury Takes on the CDS Market

Also in the news yesterday (underneath the photo-release reversal madness, which I think Glenn Greenwald has pretty much covered) was the Obama administration’s proposal to press for regulation of Credit Derivatives [emphasis added]:

The administration asked Congress to move quickly on legislation that would allow federal oversight of many kinds of exotic instruments, including credit-default swaps, the insurance contracts that caused the near-collapse of the American International Group.

The Treasury secretary, Timothy F. Geithner, said the measure should require swaps and other types of derivatives to be traded on exchanges or clearinghouses and backed by capital reserves, much like the capital cushions that banks must set aside in case a borrower defaults on a loan. Taken together, the rules would probably make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets.

The proposal will probably force many types of derivatives into the open, reducing the role of the so-called shadow banking system that has arisen around them. 

I know, not nearly as sexy as the legal intricacies of a fight against FOIA, but still important.  (Believe me, I tried for at least five minutes to think of a way to attach Paris Hilton’s picture to this, too, but I’ve got nothing).  This is a dry topic, and if I didn’t know Americans so well, I’d say the boring tedium of it all was one of the reasons no one took this up a couple of years ago when it might have actually made a difference.  Oh, wait, it turns out I do know Americans that well.  Anyway, now that the financial world is falling apart, suddenly everyone’s concerned about the “shadow banking industry,” so we might see some real change, since voluntary national alcoholism doesn’t seem like a passable strategy to get through the days.  Like Andrew Leonard says, it is a bit like “closing the barn door after the derivatives escaped,” but there are still plenty of derivatives in the barn that could use some supervision.

It turns out, though, there was somebody pushing for this exact strategy five years ago.  Wait, did you say five years ago?  I did, self, I did.  Who was this forward-thinker?

Waaait a second.  Where’s his Darth Vader mask?

In 2004, Tim Geithner gave a speech¹ on “Hedge Funds and Their Implications for the Financial System,” in which he discussed, briefly, the need for credit derivatives to be traded more openly, and with some system of regulation.  Later that year, he convened the heads of the banks and got them to volunteer to update their tracking systems and get things onto a standardized computer system, instead of everyone running their own haphazard (think: sticky notes) show.  But the actual regulation of derivatives never went any further than that, whether because Geithner lacked the power, the resources, the guts, the inclination, the kickback, the conspiracy, or the political savvy or support (please remember who was running Treasury back then) to see that it did.

So, unlike PPIP and TARP and TALF and WTF (yes I made that last one up), this is a plan that someone’s thought about for more than a week or two.  Consider this Revenge of the Government Servants.  The plan for regulating derivatives is… well, I won’t risk putting you to sleep, but it’s been in the works for a while — we heard shades of it mentioned during Geithner’s earlier Congressional testimony — and it would consist, essentially, in rolling back big slices of the Commodities Modernization Act of 2000, which was adopted under the Clinton administration and, oh yeah, as both Andrew Leonard and the New York Times point out, with the full approval of one Larry Summers.

^{“Stop trying to help, Larry! Seriously!”}

It would push for most “derivative instruments” to be traded openly, so that investors and regulators could actually get a look at the ways companies hedge themselves against risk.  And it would also require certain capital reserves to be on hand before banks could trade these things — so an insolvent, constantly-borrowing-to-survive guy like Bear Stearns would have some trouble here. 

Openness?  What?  Accountability?  On Wall Street?  Surely you jest.

Well, a little bit, I do, because one of the agencies likely to be charged with overisght responsibilities is the Securities and Exchange Commission.  If you haven’t read TPM’s overview of the scathing GAO report on the SEC, well, that’s ten minutes of appalled laughter and stomach-sinking dread that you really owe yourself.  The SEC is pretty much a dead agency.  Giving it new things to do will only help if the President and Congress have plans to staff it up — and they’d better not be sending Summers over there.  SEC restructuring or, honestly, replacement is the biggest missing piece in this plan.

But overall, this is good news.  Yes, it comes too late, and yes, it’s probably not a perfect plan, but it’s complex with some pleasantly optimistic overtones and just a hint of bitter, bitter regulatory nuttyness.  Vintage government-label work, here.  I’ll drink to it.

^{1 Should you ever have trouble sleeping, I really, truly recommend perusal of the New York Fed’s speech archive, btw.  Skip the lively speeches by the other guys — Dudley’s “May You Live in Interesting Times” is just no match for the somnia-inducing Geithner tome, “The Economic Dynamics of Global Integ...”  Wha?  What?  Oh, sorry, nodded off.}

Ten Banks Expected to “Fail” Stress Tests

It’s Stress Test Week!  (Again).  But this time, we’re talking results instead of just, you know, hey, guess what’s happening behind closed doors.  The nation’s 19 largest banks have all seen their results by now, and rumors have been flying since Monday about what, exactly, those results showed.  I thought I’d do a round-up of expectations now, and then come back tomorrow and see how the banks fared in reality.  I’ve waxed on about what the tests mean before.  And I’ve said my faith in Treasury rests largely on the results.  So here it is: judgment day.  Rumor has it, ten banks aren’t expected to pass (which is different than a bank failing outright, because if they don’t pass, they’re given time to raise capital).  Here’s the Top Ten:

Citibank is held by Citigroup.  It’s expected to need a major infusion of cash — talk is $10 billion.  Citi apparently appealed the government’s findings.  Just this week, it sold its Japanese finance company, Nikko Cordial, for about $3.4 billion (it bought Nikko in 2008 for around $18B) to raise some much-needed cash.  Citi is largely considered the bell-weather of this test, in that if it’s deemed to “pass,” the rest of the test should be considered a joke.
Current government investment in Citi: ~$45 billion (some in common stock).

Bank of America is the nation’s largest retail bank, as of last fall when it bought Merrill Lynch — and is also expected to be the bank in the most trouble, since last fall it — hey! — bought Merrill Lynch.  BoA is expected to need a whopping $33.9 billion in additional capital post-test.
Current TARP investment in BoA: ~$45 billion (unless you count the government’s asset guarantees in.  Then we’re talking 45 + $142 billion = $187 billion).

Wells Fargo was considered in prime shape this fall when it bought out troubled Wachovia, and it took money from the TARP — but only under duress.  Now, despite the CEO’s protests that the stress tests are “asinine,” the bank is considered one of the most likely to be under pressure to raise new capital.  Warren Buffet, whose Berkshire Hathaway investment group owns shares of Wells Fargo (and US Bancorp, SunTrust, and BoA) and pushed for the Wachovia takeover, called Wells and US Bancorp “extremely strong banks” Monday.
Current TARP investment: ~$25 billion.

KeyCorp owns the Key Bank franchises.  It’s considered to be widely and heavily exposed in the commerical real-estate market, which is taking some significant hits as businesses suffer during the recession.  Analysts at several research/investment firms have said KeyCorp is quite likely to need to raise additional capital, and it has shown a loss in all of the last four quarters.
Current TARP investment: ~$2.5 billion

Regions Financial is in about the same boat as KeyCorp.  Oppenheimer analysts said late last month that they expected Regions to fail the stress tests and have to raise more capital.  Regions posted a 92% loss in the first quarter.  Holy mackeral.
Current TARP investment: ~$2.5 Billion

US Bancorp owns U.S. Bank, the sixth largest commercial bank in the country.  It’s not widely expected to need a big capital raise; it cut dividends earlier this year by 88 percent to maintain its capital cushion.  Its CEO also announced late last month that US Bancorp is ready to repay its TARP money as soon as possible.  The bank had a $529 million profit in the first quarter, down significantly from past years but a better showing than expected.
Current TARP investment: $6.6 billion

Fifth Third Bancorp is another regional bank expected to need additional capital.  It’s based in Florida, where the burst of the housing bubble is still taking down everything in its path.  Like Regions, were the government to convert its preferred shares to common shares, it would own a majority stake (54 percent) of Fifth Third.  One wonders if that’s enough ownership to induce a name change.
Current TARP investment: $3.4 billion

Like Fifth Third, Georgia-based SunTrust is a considered a regional bank likely to be told to get thee more capital, according to a report issued by Mogan Stanley last month.  Then again, Morgan Stanley though BoA fell into a “grey zone” and might not need new capital, so who knows. SunTrust wrote off $610 million in bad loans just in the first quarter this year, and apparently holds a big balance sheet of home mortgage loans in the Southeast.  Last week, a huge Georgia banker’s bank with similar ugly exposure became the fifth largest bank failure this year.  In January, analysts were already predicting SunTrust would need another $2 billion.  They went back for $1B from TARP, so at this point, I’d guess they’ll need at least $1B.
Current TARP investment: ~$5 billion.

PNC Financial Services Group posted a profit last quarter, mostly on the strength of its acquisition of National City — a move that some say gave the bank a needed capital boost.  Analysts at Keefe, Bruyette and Woods say PNC is likely to need more capital despite cutting dividend payments earlier this year.
Current TARP investment: ~$7.5 billion

And lucky number 10.  Capital One Financial Group is mentioned with some regularity as a bank expected to need additional capital.  Its exposure is largely in credit cards, and as unemployment rises (in the stress tests, it went over 10 percent) so do expected defaults on credit card payments. 
Current TARP exposure: $3.5 billion

Ten banks are expected to have “failed,” or, in the nicer terminology, to need to raise new capital so as to have a nice cushion in case of the economy continuing to decline.  The remaining nine banks are considered variably secure right now, though BB&T is mentioned in several articles as likely to be asked to raise capital, too, and I’m a little surprised that no one thinks GMAC is going to need any further funding.
Current BB&T TARP Investment: ~$3 billion

Current GMAC TARP Investment: $5 billion

The remaining banks (bank holding companies) are:

• J.P. Morgan Chase.  Current TARP Investment: $25 billion
• Goldman Sachs Group.  Current TARP Investment: $10 billion
• Morgan Stanley.  Current TARP Investment: $10 billion
• State Street Corp.  Current TARP Investment: $2 billion
• Bank of New York Mellon.  Current TARP Investment: $3 billion
• American Express Co.  Current TARP Investment: ~$3.4 billion
• MetLife.  No TARP Investment.

Well, so, let’s see what happens now.

Gov’t for Grown-ups: I have Federal Reservations for 3

I’ve neglected this series for a long time.  Not for very good reasons — it can mostly be summed up by “writer’s block,” having to do with a precipitous drop in my ability to write about Congress in an informative manner instead of one laced with profanity.  So I’m back, and I’m refocusing my attention, at least for now, on institutions, instead of political positions.  If I’m going to want to burn something down, better it be an entire building constructed from marble than a man in a suit.

So, let’s talk The Fed.

This is going to be a long talk, so I’m breaking it into three tasty pieces: A Brief History of U.S. Banking (1790-1930ish); The Federal Reserve, from Depression to Inflation (1930ish to 1980ish); and The Post-Modern Fed (1980ish to current) — if the TALF is still alive by then.

There will be a one-week guacamole intermission between posts.  Guacamole making and consumption is also encouraged while reading — if you need to step away, I’ll still be here.  Take your time.

A Brief History of U.S. Banking.

At the same time America became a country, it was also, in the great American tradition, broke.  A debate ensued about what to do — pay off the debts incurred by states before they were even states?  Say “screw it” and move on?  It was hard to decide what to do — individual states, and sometimes even individual cities and banks, were using different notes to denote debts, so it was hard to say what was even owed.

Enter Alexander Hamilton.  I should at this point again disclose a fascination and admiration for Hamilton, the father of the U.S. banking system and probably a total jerk to hang out with.  In 1791, Hamilton, the first Secretary of the Treasury, convinced Congress to create the First Bank of the United States, arguing in part that a strong financial institution would benefit everyone by making the nation itself stronger and more certain to survive:

[A]n attentive consideration of the tendency of an institution immediately connected with the national government which will interweave itself into the monied interest of every state, which will by its notes insinuate itself into every branch of industry and will affect the interests of all classes of the community, ought to produce strong prepossessions in its favor in all who consider the firm establishment of the national government as necessary to the safety & happiness of the country, and who at the same time believe that it stands in need of additional props.

This was a hard argument to make to a country skeptical of any broad central grant of power.  Yet Hamilton, who also established the U.S. Mint, managed to win a 20-year guarantee for the First Bank.  Sadly, it outlived him, then lost its own duel with Congress — by one vote, the bank wasn’t renewed in 1811.

Yet by 1816, the U.S. was hungry for some central, organizing force to look over banks, bankers, and monetary policy.  So the Second Bank of the U.S. came to life.  You probably know how this story ends, but let’s let the White House history of President Andrew Jackson tell it:

The greatest party battle centered around the Second Bank of the United
States, a private corporation but virtually a Government-sponsored monopoly. When Jackson appeared hostile toward it, the Bank threw its power against him.

Clay and Webster, who had acted as attorneys for the Bank, led the fight for its recharter in Congress. “The bank,” Jackson told Martin Van Buren, “is trying to kill me, but I will kill it!” Jackson, in vetoing the recharter bill, charged the Bank with undue economic privilege.

So, back to no bank.  Ho-hum.  The U.S. muddled on with no national currency until the National Banking Act of 1863 essentially black-mailed people into adopting national notes, by a) creating them and then b) establishing a tax on state-issued notes, but not federal notes, which were backed by treasury securities.  Yes, yes, they had securities back then, too.  People still traded in state-based notes, because people are irrational, but the spread of national currency gained some footing.

Yet this “national banking system” had its own snags [.pdf]:

Under this system, “country banks” were required to hold reserves at larger banks as well as in the form of cash. ”Reserve city banks” were required to hold reserves in cash and as deposits in “central reserve city banks.” Central reserve city banks were required to hold their reserves in cash. The Treasury Department altered reserve levels by adding or draining funds that it kept on deposit at central reserve city banks. The large city banks were unable to respond adequately to seasonal and cyclical variations in the cash and credit requirements of the economy. The years were marked by periodic financial crises that were resolved primarily through emergency actions of private bankers.

Those “bankers” we led by J.P. Morgan, who was kind enough to bail out the system in 1893 when panic ensued.  In 1907, he did it again — and public opinion, long opposed to the very idea of a central bank, suddenly swung more decisively toward desirous.

But hey, this is government — why rush into anything?  Congress, being Congress, appointed a commission to look into the best way to tackle the banking problem.  Meanwhile, William Jennings Bryan stormed the country cheering for the Silver Standard (and was immortalized as the Cowardly Lion in “The Wizard of Oz” for his efforts).  Finally, President Wilson leaned on Congressman Carter Glass to get something done, and in 1913 the Glass-Willis bill, known as the Federal Reserve Act, birthed the modern Fed, a bouncing several-million-dollars baby.  It established:

• Twelve regional bank districts
• That all national banks had to buy into the Fed at a rate of six percent of the bank’s current capital stock, in exchange for voting rights
• That should the Fed not have sufficient money through bank and personal buy-ins, the Treasury Department would buy in.
• The Federal Reserve Board’s power to examine “accounts, books, and affairs” of member banks
• Individual regional boards’ power to set Discount Rates — the interest rates at which banks could borrow from the Fed.
• The Federal Reserve as the “lender of last resort,” where banks could turn when they faced a panic.
• The Federal Reserve as the primary issuer of Federal Reserve Notes — what we now know as “dollars.”  A sample from the first run, Series 1914, is seen above, starring Grover Cleaveland.

The four big provisions that came out of the Fed’s charter were “to
provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”

Ta-Da!  A Central Bank at last.  The actual responsibilities of the bank, other than to provide stability to the system, were somewhat undefined for the next two decades, however.  The bank dabbled in the 1920s with some Open Market interventions, but with little success — though aware of the speculation bubble of the late 20s, it did little (and some might argue it could do little) to stop it; it did even less to alleviate the stress on banks as the downturn turned into a full-blown Depression.  In fact, the Reserve Board and the governors raised some rates in the early 30s and wanted to raise rates further, through a sell-off of treasury securities, even as things got bad again in 1932.

Which takes us to the fall of the first Fed system, with the introduction of Franklin D. Roosevelt’s financial policies and politics.  But if you’ve made it this far, I’d guess you’re as ready for a guacamole break as I am.  So we’ll pick up here next time — though in the interim, if things are unclear above, throw me questions in the comments.  I’m trying to compress many sources into one long explanation, so I may have made things blurrier — and I’m happy to help clarify, as I can. Likewise, if I’ve skipped something vital — well, you’ll tell me, right?

Till next time, then.