Nathaniel Popper’s story this week in the New York Times on the state of banking Iceland underscores how history makes a mess of neat divisions between financial crisis containment/resolution on the one hand and financial regulation for crisis prevention on the other. The Times article does not delve extensively into Icelandic regulation, but this report outlines some of the dramatic changes in that country’s financial regulatory architecture since 2008 (see pages 17-21). Iceland chose to let banks fail, and its financial services sector and its approach to regulation continues to reflect that choice.
The following insight may sound obvious to the uninitiated: the path that a country chooses to deal with a financial crisis shapes the course that regulation will take after the crisis ends. Even so, there remains a stark divide in scholarship between the study of regulation in normal times and the management of financial crises in not-so-normal times. Management of a financial crisis reflects not just ad hoc decision-making under fire, but also clear policy and value choices of what the legal landscape should look like when the earth stops shaking.
This story with respect to the United States can be told with much more nuance than simply equating the bail-out of big banks with the government green-lighting business as usual on Wall Street. Disaggregating the “bailout” into its constituent parts – not just TARP, but also a series of bespoke interventions and an array of Federal Reserve facilities – reveals the extraordinary lengths the government went to in order to preserve the shadow banking system (a topic I’ve been writing about for a while and that appears in my new book) as it was.
Christian Johnson’s chapter on the Federal Reserve and Section 13(3) (which appears in this excellent edited volume) provides a travel guide to these government interventions. Consider the least known aspects of the government intervention, the Federal Reserve facilities that provided guarantees and liquidity to various financial markets during the crisis. Chewing through the letters of this alphabet soup – from ABCPMMMFLF (asset-backed commercial paper money market mutual fund liquidity facility) to TALF (Term Asset- Backed Securities Loan Facility) – it becomes clear that the government attempted to save securitization, money-market mutual funds and other shadow banking markets. How did the Federal Reserve accomplish this? It created complex structures that essentially replicated the mechanics of shadow banking. In essence, the government became sponsor to one after another mammoth securitization vehicles.
And now the Economist tells us that securitization is back!
What’s the problem? To start with, with these interventions, the government essentially adapted the same tools governments have used to fight banking crises throughout history to fight the (the first (so far)) shadow banking crisis. What were the government interventions – both equity infusions, loans, and guarantees – if not deposit insurance for shadow banking investments, the government acting as liquidity-provider-of-last-resort to shadow markets, and the government resolving institutions that failed because of shadow banking investments. However, the government offered all these forms of relief without acting like a bank regulator – charging an appropriate premium for insurance or loans or wiping out shareholders of failed institutions.
So we had a shadow system that performed the same functions as banks, posed the same risks as banks, suffered runs and failed just like banks, was rescued just like banks, but was never regulated like banks. (For more on the role of regulation in fueling the shadow banking bubble, see Chapters 10 and 11 of my book).
And now that securitization has returned, the continuing failure of financial reform to address the risks of shadow banking has become even more worrisome. What me worry? We can’t have another crisis so soon after a bubble popped? The financial industry and its advocates hate the term shadow banking. Why? Because disaggregating the financial crisis into various technocratic failures, allows them to say the problem has been fixed by the bubble gum (pun half-intended) and shoe string patchwork of financial reforms, and even to argue that this patchwork goes too far.
To return to lesson of Iceland: the course of financial reform may have been set in the first responses to crisis management. We could see that the government wanted to preserve shadow banking. And a second lesson from Iceland: the government’s success in preventing a deeper crisis likely took the political wind out of the sails of deeper and more effective financial reform.
After over four years of work, my book Law, Bubbles, and Financial Regulation came out at the end of 2013. You can read a longer description of the book at the Harvard Corporate Governance blog. Blurbs from Liaquat Ahamed, Michael Barr, Margaret Blair, Frank Partnoy, and Nouriel Roubini are on the Routledge’s web site and the book's Amazon page. The introductory chapter is available for free on ssrn.
Look for a Conglomerate book club on the book on the first week of February!
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One of the many disasters of the financial crisis involved the bankruptcy of Lehman Brothers, which was marked by a race to the courthouse doors by creditors in most places Lehman had a substantial number of assets. It also, given the number of subsidiaries Lehman had created, was very complicated to discern even which assets were domiciled where.
Anyway, the consensus has been that a cross border resolution regime for big banks is needed, in light of the Lehman problems. But very little progress on this high priority of the G20's has been made. All of which brings us to the latest speech by a German banker urging that a cross-border deal be arranged. Does that mean a treaty? Evidently not. The German central bank thinks that agencies like the FDIC should come up with a cross-border resolution authority protocol, and that that should do it.
Essentially, the firm, and its Sullivan and Cromwell lawyers, are arguing that the FDIC has breached its contract in inducing the firm to buy up Washington Mutual. That contract, it is argued, provided an indemnity for the thrift's legal liabilities. The key issue is whether JPMorgan "expressly assumed" those liaiblities when it bought WaMu. If it didn't, the FDIC might have. I am no contract expert, but I do not find this argument to be uncompelling.
Here's the relevant language from the complaint:
the FDIC-Receiver agreed to indemnify JPMC for, among other things, "any and all costs, losses, liabilities, expenses (including attorneys' fees) ... , judgments, fines and amounts paid in settlement actually and reasonably incurred in connection with claims against [JPMC]" insofar as they are:
• "based on liabilities of [WMB] that are not assumed by [JPMC] pursuant to this Agreement." (P&A § 12.1.)
• "based on any action or inaction prior to Bank Closing of the Failed Bank, its directors, officers, employees or agents as such, or any Subsidiary or Affiliate of the Failed Bank, or the directors, officers, employees or agents as such of such Subsidiary or Affiliate."
• "based on the rights of any creditor as such of the Failed Bank, or any creditor as such of any director, officer, employee or agent of the Failed Bank or any Affiliate of the Failed Bank, with respect to any indebtedness or other obligation of the Failed Bank or any Affiliate of the Failed Bank arising prior to Bank Closing." (/d. § 12.1(a)(2).)
HT: Jennifer Taub. And happy holidays!
For those of you wanting to keep tabs on the soon-to-be-final Volcker Rule, here are some important links. Here is the fact sheet (released today). Here is the board memo accompanying the final rule from yesterday. The full proposed rule as printed in the Federal Register.
In a nutshell, the rule will prohibit "banking entities" from engaging in "proprietary trading" and owning "covered entities." The meat, of course is in the definitions and exceptions. The term "banking entity" is going to basically cover any bank holding company or other insured depository institution operating in the U.S., including affiliates, subsidiaries, parent companies, etc. Nonbank financial companies are exempt from these prohibitions but may be subject to other capital requirements. Proprietary trading activites are prohibited, but market-making, risk-mitigating hedging, underwriting and trades necessary to provide liquidity are exempt. Certain investments in covered entities, hedge funds and private equity funds, are exempt. And the kicker -- executives have to certify that the bank has "taken steps" to comply with the rule, though they don't have to certify actual compliance.
So, will this take away the benefits of being a BHC for Goldman and Morgan Stanley? Maybe, though I read at least one commentator say that should these "too big to fail" entities opt out, regulators could just change the definition of "bank entity" to include "systemically important financial institutions" (SIFIs).
Hard to believe, but the Volcker Rule was proposed in 2011. Here is a great series of posts by friend of the Glom Kim Krawiec on the making of the Volcker Rule.
Finally, if you want a good read on the very profitable road from matching customer trades to proprietary trading, The Partnership: The Making of Goldman Sachs, is a very interesting read.
The $13 billion dollar settlement with JPMorgan over violations made by companies it bought during the financial crisis appears to be all but final. You may think it is a much-awaited example of finally getting tough with financial institutions, but you may also be wondering about the fairness of it all. Were these bankers doing things that are different from other bankers? Why aren't those other bankers paying commensurate fines? Is this like the LIBOR scandal, where many banks were involved but only one, Barclays, paid with the loss of its CEO?
It is like that. But if you want to make peace with this sort of government enforcement, here is how you do so:
- Making an example. These sorts of enforcement actions tend to amount to a form of the original meaning of the term decimation. The idea is that the dramatic punishment of a few will deter the many, which means that those singled out can expect - maybe reasonably, even as they bemoan their bad luck - severity.
- Limited resources. But building a case is difficult, and so the government is wise to concentrate on the famous, given that it cannot hope to enforce against everyone - the Wesley Snipes principle, if you like. JPMorgan is the most famous of the banks, the most in the news, and therefore the most tempting target if your goal is to maximize the impact of a necessarily limited set of enforcement actions.
- Contract misrepresentation damages. Half the settlement is not so much a fine as it is compensation to misled investors. In this sense, part of that big number is very much simply a measure of an expectancy not realized. It is that sort of remedy that you'd think would most likely be paralleled in proceedings, perhaps initiated by private parties, against other banks.
I don't mind the occasional bailout. For financial institutions, unless you're headed into a depression, they often don't lose the government money; instead you hang onto volatile assets until they mature, and when they mature, volatile instruments become more predictable. And often there isn't an alternative to bailing out an important financial intermediary, either. That doesn't mean you celebrate bank bailouts; the loss of discipline on the banks - that is a terrible thing. But it often ends up being the bitter you have to take with the not so sweet, but not so sour either. They do not have to be massive money losers - just time-to-repayment shifters.
Still, we knew that industrial company bailouts might present their own problems. And Treasury hasn't held onto GM long enough for it to bounce back (nor is it obvious that that would eventually happen):
Treasury would need to get $147.95 on its remaining shares to break even. That’s not going to happen: GM’s stock closed Wednesday at $35.80, up $0.21, or 1 percent. At current trading prices, the government’s remaining stake is worth about $3.6 billion. At current stock prices, taxpayers would lose about $10 billion on the bailout when all the stock is unloaded.
Earlier this month, Treasury reported it sold $570.1 million in General Motors Co. stock in September, as it looks to complete its exit from the Detroit automaker in the coming six months. The Treasury says it has recouped $36 billion of its $49.5 billion bailout in the Detroit automaker. The government began selling off its remaining 101.3 million shares in GM on Sept. 26, as part of its third written trading plan.
It will lose $9 billionish on the deal. It isn't obvious to me that Treasury has interfered overly with the corporate governance of the auto companies once it took them over. But it did insist on the divestment of a ton of auto franchises, may have pressed GM to sell Volts, and, in the end, lost money. That's not exactly a record to celebrate, even if you do conclude that some sort of intervention was necessary.
I've been watching the various bailout takings suits against the US government with interest. There are two in particular that are proceeding apace. One is a suit by Chrysler and GM auto dealers who lost their franchises, in their view at the behest of the government, in exchange for the bailout of those companies. Those plaintiffs have done well before the Court of Federal Claims, but will have to defend their efforts in an appeal certified to the Federal Circuit next month.
The other is a suit by Starr, Inc., controlled by Hank Greenberg, the former CEO of, and major stockholder in, AIG, againt the government for imposing disproporionate pain on AIG owners vis a vis other financial institutions that received a bailout. That case has also done well before the CFC, and is now in discovery. And David Boies, Greenberg's lawyer, hasn't kidding around about the discovery, either. He has already deposed Hank Paulson and Tim Geithner on what they knew (presumably a lot), about the decision to structure the AIG bailout the way they did, and he noticed a deposition of Ben Bernanke that required the government to use a mandamus appeal to quash it, which it semi-successfully did last week.
It wasn't a thoroughly convincing quashing, though. High ranking officials in office aren't supposed to be deposed, except when there is a showing of extraordinary circumstances, for two reasons. It's disruptive, and it interferes with the deliberative processes of government.
These concerns go away, however, when you leave government. As the Federal Circuit said, "There appears to be no substantial prejudice to Starr in postponing the deposition of Chairman Bernanke, if one occurs, until after he leaves his post. The deadline for discovery should, if necessary, be extended beyond the current close on December 20, 2013, for that purpose."
I'm not sure that Bernanke's deliberative process will actually tell the Starr plaintiffs very much about their case. With takings claims, the focus is on what the government did, and whether that constituted a taking, rather than on why it did it. A deposition might offer some details on whether the government was imposing a cost on particular people that should have been borne ratably by the taxpayers, which is what the takings clause is supposed to protect (Starr would probably like Bernanke to say that the government zeroed out AIG shareholders to punish them for failing to make sure their firm was being operated cautiously, for example). But again, the question is whether, not why.
It does mean, however, that Bernanke can be pretty sure of at least one thing when he leaves the Fed. He'll soon be under oath, testifying about the reasons why the AIG bailout was structured the way it was.
Bloomberg has done the arithmetic, and it appears that US banks have paid over $100 billion in legal costs in the wake of the financial crisis. Half of that is going to mortgage settlements, a number that must increase, if JPMorgan's impending $11 billion settlement is for real.
Those burdens have not been spread equally:
JPMorgan and Bank of America bore about 75 percent of the total costs, according to the figures compiled from company reports. JPMorgan devoted $21.3 billion to legal fees and litigation since the start of 2008, more than any other lender, and added $8.1 billion to reserves for mortgage buybacks, filings show.
Most of this constitutes compliance fines and contract damages - and the latter presumably would have been paid if the contracts had been executed correctly. But the costs of processing these payments suggest that there is at least one legal sector with plenty to do. HT: Counterparties.
A former trader with Goldman Sachs, Steven Mandis, is now spending time at Columbia Business School, and has written a very business schooley book about change at the company. It might be the kind of thing you'd like, if you like that sort of thing. Peter Lattman provides the overview:
Mr. Mandis said that the two popular explanations for what might have caused a shift in Goldman’s culture — its 1999 initial public offering and subsequent focus on proprietary trading — were only part of the explanation. Instead, Mr. Mandis deploys a sociological theory called “organizational drift” to explain the company’s evolution.
These changes included the shift to a public company structure, a move that limited Goldman executives’ personal exposure to risk and shifted it to shareholders. The I.P.O. also put pressure on the bank to grow, causing trading to become a more dominant focus. And Goldman’s rapid growth led to more potential for conflicts of interest and not putting clients’ interests first, Mr. Mandis says.
It's coming out from and Havard Business Press Books, which is basically an arm of HBS's distinctive revenue generator. Most of that revenue comes from cases sold for b school classes, to be sure, but Mr. Mandis can hope that he will have a hit on his hands.
- While we wait for news that JPMorgan will pay $800 million + an admission of wrongdoing to settle the London Whale trade, it turns out that the SEC has entered into "no admit, no deny" settlements with a passel of short sellers. We'll see how much the agency's new quest for accountability meshes with the need to close cases.
- Sheila Bair came to Penn, and here's what she said about reforming financial regulation.
- More evidence that the New York financial supervisor and the national ones are carving out different regulatory perspectives: favored bank consultant Promontory is being investigated by the former, even as it is hired to pitch the latter for client forbearance.
Lehman Brothers failed five years ago, and the statute of limitations for most federal crimes is five years, so the restrospectives are full of recountings of the fact that no one important has been prosecuted over what happened. Here's an example, and, look, I'm surprised as well. If you could convict Ken Lay over things his subordinates did and his own "we won't stop trying to save this company and I'm confident we will succeed" statements, it's pretty surprising that not a single banking CEO has faced a similar fate.
But no jail time doesn't mean nothing, and the SEC's decision to reject a settlement over the mutual fund that broke the buck after Lehman failed, basically destroying the whole asset class until the Fed jerry-rigged an insurance scheme to save it, is an example of this. It shows that the government is looking to civil, rather than criminal penalties. It isn't clear to me that those cases are more winnable. But that appears to be the strategy. Along those lines, here's a nice argument that the government has changed some things since the crisis unfolded.
If you didn't see it, the Wall Street Journal brings word, straight from Eric Holder's mouth, that yes, there will be some financial crisis cases brought. The AG said:
....anybody who's inflicted damage on our financial markets should not be of the belief that they are out of the woods because of the passage of time. If any individual or if any institution is banking on waiting things out, they have to think again.
The only thing is, the passage of time is beginning to hem in DOJ. The world went crazy in September, 2008 - five years ago next month. And the ordinary statute of limitations for federal cases is five years. What can we surmise from this?
- Some people really can start to breathe easier. Although the crisis became spellbinding with the collapses of Fannie, Freddie, AIG, and Lehman Brothers, the securitization markets had already pretty much ground to a halt by 2007. Bear Stearns had fallen. There are some statutes - criminal mail and wire fraud, for example - that, unless I'm missing something, cannot be invoked for matters that happened then.
- Those people do not include those who committed bank fraud, or fraud "affecting a federally insured financial institution." Under FIRREA, these defendants are covered by a ten year statute of limitations, lashings of time. FIRREA can get the government civil monetary penalties, but not criminal ones.
- So if Holder is planning some press conferences, he's likely doing so for criminal cases that would be associated with the events of the fall of 2008, or civil cases that have a much broader scope, but probably do not involve a hedge fund lying to a money market fund, or something that does not involve FDIC insurance.