The Goldman Exit

Goldman Sachs’ ability to raise capital on Tuesday and its announced desire to pay back the funds obtained from the TARP program is forcing the administration and banking agencies to rethink how they plan to deal with the results of the stress tests they have been conducting.  Initially, institutions were instructed not to disclose the results of the tests.  The logic was essentially the same as the logic to provide TARP capital support to the major banks and investment banks.  That is, if certain firms were singled out to take TARP funds and others declined because they didn’t need them, then the concern was that those firms that got the funds would be stamped as weak or fragile.  As a consequence, they would have trouble obtaining or retaining their funds, and customers would be reluctant to do business with them.  By forcing all large institutions to accept TARP funds, the belief was that this would blunt or eliminate any stigma that might be associated with the program.

However, it has turned out that TARP funds came with what have proved to be unanticipated and costly strings attached.1  They include not only warrants and the interest costs of the subordinated debt issued to the government, but also restrictions on executive pay, increased pressure to expand lending and to engage in mortgage foreclosure mediation, government involvement in boards of directors meetings, and other micro-management initiatives that seem to be expanding in scope as time goes on. 

The original TARP program did not contemplate early repayment of the funds.  Recipients would have been required to keep the funds for three years.  However, the plan has been modified to permit early repayment, and several smaller banks have redeemed their preferred shares.  But the exact conditions for repayment by the nation’s largest banks are still murky.  Speculation has it that a successful stress test and the demonstrated ability to generate private-sector capital to replace the government capital are likely to be preconditions.  Goldman’s efforts to repay the funds on a timetable shorter than had been anticipated will force the Treasury’s hand.   If Goldman gets out from under the TARP program, its exit may signal to the market that it not only has passed the stress test but is deemed to be financially viable.  But this could stigmatize those firms that are either unable or unwilling to also exit the program, facing the administration and regulators with a critical dilemma.

Not releasing the stress test results threatens to stigmatize the remaining TARP recipients, particularly if Goldman is allowed to leave the program.  Furthermore, other firms not needing the support will have the incentive to rush to execute a Goldman-like exit, leaving only the weak behind.  In finance, we would term this a separating equilibrium. 

Should the government now releases the stress test results, this would simply serve as another explicit way to separate the weak from the strong.  Release of the results might dampen incentives for stronger institutions to rush to leave the program, but the risk that the weaker institutions would be stigmatized could be heightened. 

So, what should the administration and agencies do?  First, we need to recognize that it was a mistake to have set up the program in such a way that participants were not first required to write off their bad assets before government funds were supplied.  Weak institutions can’t be permanently insulated from market discipline by allowing them to hide among a group of healthy institutions.  There is simply too much information being required of publicly traded firms for this to be a longer term or viable solution. 

Second, as has already been noted, the costs to healthy institutions of participating in the program seem to clearly outweigh the benefits.  Third, the solution does not lie in disclosing only aggregate or summary stress test results, because healthy institutions will have strong incentives to make themselves known, either through strategic leaks or through other revealing signals in their financial reports and disclosures. 

All of this suggests that the agencies should release not only the results of the tests but how they were structured, implemented, and scored.  Doing so would actually constitute a significant and tangible de facto strategy for weaning of our largest financial institutions from government support and be a baby step retreating from both the too-big-to-fail policy and the moral hazard risks that accompany government support.

The public benefit from Goldman’s exit may be that it jump-starts a return to reliance upon market incentives to do what the regulators have been reluctant to do.  That is, to confirm what TARP participants’ financial disclosures are already likely to suggest about the relative health of the largest banks.  This will be a good result and will hopefully accelerate a healing process that is long overdue.

1These were not anticipated in our previous commentaries on the TARP rescue program.

Regulatory Malfeasance and the Financial System Collapse

Kotok comment: we are pleased to forward this guest commentary by Professor Joe Mason.  In it he outlines ways in which the securitization process went awry and led to the financial crisis we have been experiencing.  Joe notes some of the warnings.  He also furnishes a link to his recent paper on mortgage servicing which we have read and recommend to our readers.   We thank Joe for permitting us to share this missive with our readers.

Joe Mason wrote:

Greetings from Rome! While I look forward to the Banca d’Italia’s program on “Financial Market Regulation after Financial Crises,” on Friday National Journal features correspondent Corine Hegland published a rather scathing account of risk transfer in securitization entitled “Why the Financial system Collapsed” (available at If anyone wonders why regulators did not recognize the growing problem of risk on bank balance sheets over the past decade, this article is a good starting point.

Ms. Hegland begins by explaining to readers the distillation process of securitization. In short, when a securitization throws off a preponderance of risk-free debt in the form of AAA-rated securities, there must be a complimentary – albeit smaller – proportion riskier lower-rated securities that absorb the losses. In February 2007, I asked “where the risk went?” As I knew back then and Ms. Hegland clearly describes in her article, the risk never left the originating institution (the sponsor), typically a commercial bank.

Think of the problem this way. If a bank sells a pool of loans with an expected loss rate of two percent, they can’t really sell the two percent. They could discount the price, but that is just taking the two percent loss now rather than later. But if losses turn out to be less than two percent the bank made a bad deal. So the bank usually prefers to keep the first loss piece – called the residual. Hence, the expected loss is retained.

While I have written about this previously, Ms. Hegland does an incredible job of describing the degree to which regulators knew about the problems with risk transfer and willfully looked the other way. Ms. Hegland not only shows how regulators memorialized such practices in regulatory rules, moving away in 2004 from requiring a transfer of a “majority” of risk to merely requiring a structured finance arrangement to transfer “some” of the risk.

Where the article really gets fun is where it cites explicit warnings by none other than Fannie Mae and Freddie Mac that such relaxed standards would indeed result in a shell game, where partial or nonexistent risk transfer would cause a financial crisis. In the words of Freddie Mac in response to notice of proposed rulemaking in 2001 (as published in the National Journal), such practices would encourage banks “…to structure securitizations that reduce their capital requirements to a fraction of what they would otherwise be required to hold, even though the risk exposure remains the same. The results could be a net reduction in the amount of capital in the banking system to protect against credit risk.” Fannie Mae said even more clearly back then, “There should be equal capital for equal credit risk, regardless of the form in which the risk is held.”

While Ms. Hegland’s article is a good jumping off point for many who are just now learning about securitization (and perhaps trying to structure bailout programs for the large institutions who took advantage of the perverse regulatory rulemaking), it is still just an introduction. The next step lies in better understanding the terms and triggers of securitizations to recognize perverse incentives apparent in selling the AAA securities but keeping the risk, while also servicing the loans. My recent paper, "Subprime Servicer Reporting Can Do More for Modification than Government Subsidies" (which just made the Social Science Research Network’s Top Ten download list for the Financial Economics Network Professional & Practitioner Paper Series, available at shows that while securitization deal terms that require servicers to hold residual stakes can properly align incentives in steady state market environments, they can create perverse incentives when markets are in free-fall. Right now, therefore, a preponderance of servicers are using any means necessary – including modifying loans whether borrowers can pay or not – to keep securitizations in which they hold residual and junior bond stakes away from triggers that can move their own investment stakes from first in line to last in line.

Shrewd investors know that if mortgage pools perform well, those junior stakes are repaid in the first few years of the deal. If, on the other hand, mortgage pools perform poorly, those junior stakes go to last in line after everyone else is completely paid off. So while nobody in policy circles wants to talk about it, tranche warfare has erupted, with senior investors fighting junior investors to maintain credit enhancement that protects senior investor value as junior investors who control the servicing are delaying inevitable delinquencies and losses – the key measures of pool performance – through various strategies including modifying anything that moves, delaying the sale of foreclosed homes, and even inside dealing in home markets to prop up reported sale prices.

In summary, financial markets are a long way from fixed. Policymakers need to take advantage of calm markets to work on reform, so that we will have fewer panics in the future. Otherwise, we are destined to keep repeating the same panics over and over.

Joseph R. Mason – Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information:; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on

Does the Stock Market Rally Have Legs?

Is this rally real?  Does it have legs?  Questions like these are now raised daily by investors and by TV anchors on the financial shows.  The CNBC Power Lunch fearsome foursome panel called me a “dodger” when I wouldn’t take their bait last week. 

Our response was then and still remains: the answer is a definite, 100% “Maybe!”  You can see the interview on .  Search under “kotok”.  All three segments are listed under April 6.

Ok, let’s go back to the rally question raised on CNBC’s Power Lunch.  Stocks seem to have established a serious interim (if not permanent?) low on March 9, when the S&P 500 index hit 666.  We initially thought the November 20 low would mark the interim bottom but we were wrong.  The question now involves 666. 

Since the March 9 low, the S&P 500 has rallied strongly.  Using the ETF that is supposed to track that index, with the “spider” symbol SPY, we note that from March 9 to the April 9 pre-holiday close, SPY has delivered a total return of 26.9%.  Perhaps more importantly, the equal-weighted S&P 500 ETF, symbol RSP, has outperformed the cap-weighted SPY by ten points.  Since March 9, RSP is up 36.2%.  This is a continuation of the broadening market trend we have seen since the November 20 low.  A widening acceptance of stocks and broadening buying is a very favorable sign.  Note that Cumberland has switched from SPY to RSP in our “core” ETF strategy for the US market.  We did that after the November low and as soon as we saw the market broadening.  When the stock market is broadening, you want to be more equal-weighted; when it is narrowing out of fear, you want to restrict to the very largest caps, which are viewed as the safest. 

Okay, so the answer to our rally question is “so far, so good.”

There are many favorable signs.  Elements in the credit markets (like commercial paper rates and money market funds) are functioning and improving.  Where Fed policy has been applied with enough size and precision, the result has been to ease the market and repair some of the damage.  There is every reason to believe the Fed will persist in this approach and enlarge it.  Consumer finance and housing finance are the current big targets; hundreds of billions will be thrown (lent) at those sectors.

On the list of unfavorable signs, we note that other sectors that have improved from their worst case are still not fully functional.  LIBOR at 3 months is still nearly 100 basis points higher-yielding than the 3-month Overnight Indexed Swap rate (OIS).  Banks still do not trust each other when it comes to default risk.  Many banks are electing to lend excess reserves to the Fed at a yield of 25 basis points rather than to each other at a yield of 125 basis points.  We see this distrust in the very wide spreads between bank debt backed by the FDIC vs. debt of the very same bank that is not FDIC-backed.  The spreads are huge. 

Last week’s Wells Fargo-led rally aside, markets do not trust the banks.  They trust the FDIC.  For proof, watch the rates on CDs between $100,000 and $250,000 as the maturities go beyond the existing temporary FDIC insurance on the higher amount.  Markets also do not trust the government programs when it comes to durability and consistency.  Who can blame them?  When it comes to the rules, the government seems to change its mind every week.

Another unfavorable sign is found in the corporate credit spreads.  A study of longer-term, lower-risk corporate bond spreads confirms the predictive ability of credit spreads in this sector. They were an early warning sign for the 2007-8 crises.  Indications today are that we are headed for a worsening of the employment situation.  In fact, the statistical work from this excellent research suggests that as many as another 7 million jobs will be lost before the recession ends.  That is on top of the 5 million already lost.  We will have more to say on the employment situation below.  The study is to be published in the Journal of Monetary Economics and is written by Simon Gilchrist and Vladimir Yankov.

This study has us concerned, because the biggest open question for us is in the jobs arena.  Normally the employment statistics are considered to be lagging indicators.  Normally the unemployment rate continues to rise as the economy bottoms and commences a recovery.  Likewise, the unemployment rate tends to hit its lowest point after the growth rate of the economy has peaked.  Normally, there are corresponding movements in profits.

The most robust profit growth comes at the time the economy is exiting a recession and beginning to recover.  Firms that are still survivors have become lean and mean and experience rapidly widening profit margins as business picks up.  They do not immediately hire back their furloughed workers.  Instead, they deploy their capital investment in the sector that gives them the fastest payback with a productivity gain from the remaining workers.  That is why the tech sector does so well coming out of recessions.  Note that Cumberland has overweighted the tech sector and many of its subsectors, with software being the most intense overweight.

So history would say that jobs are lagging indicators and that this March 9 low was “the” low.  But we worry that this time may be different.  We are investing as if the rally is real and will have legs.  We think we are seeing a V and that March 9 was the bottom.  But we worry that it may really be a W.  Remember, the upward leg of the V and the first upward leg of the W look the same when you are in them.  We are prepared to reverse our position if our fear is further supported by forward-looking data. 

V or W?  Here is the fear. 

The unemployment rate is now about 8.5% and still rising.  Most of the forecasts we respect have it peaking at between 9.5% and 10%.  That peak is another six months to one year in the future.  After that, the unemployment rate declines very slowly.  Remember, this measure of recession has doubled in the last year.  The unemployment rate in the US was 4% only a short time ago.  This is a huge shock, and it is the size of the shock that worries us.  And if the corporate bond spread forecast mentioned above is correct, we may see the unemployment rate above 10%.

There is another issue that hides below the radar screen.  We have numerous anecdotes about the 7 to 12 million undocumented workers who can be seen in our construction and service businesses.  They produce a driver’s license and ID and they get a paycheck.  They appear in the payroll surveys and in data compiled from payroll tax filings.  When they are laid off, they tend not to apply for unemployment benefits, and they tend to avoid surveys.  They are afraid of deportation.  That means the employment statistics are deceiving us, because they are counting these folks in the payroll data when it is positive but are not capturing the same workers in the unemployment numbers. 

Ned Davis Research has attempted to reconcile this and other gaps.  NDR concluded on April 3 that “Adjusting the household survey to the payrolls concept resulted in a large loss of nearly one million workers (ouch!), narrowing the gap between the two surveys, and eliminating a potential positive.”  If NDR is correct, the recent employment report was really ugly, and markets have misread it as moderating. 

Many of the employment statistics are very bad.  The “underemployment rate” is about 16%.  Remember, if a mid-management executive loses his $80,000-a-year job and finds another one as a $15-per-hour administrative staff person, he is counted as employed in either category.  Clearly his household has been hurt by the loss of income.  The underemployment statistic is an important one to watch.  It is at a record level.

Barclays (April 3) notes that “A turn in job growth does not always last: in the long 1982 recession, there was a double bottom in employment growth, and in the 2002-2007 expansion, there was a mini-jobs recession in the run-up to the war in Iraq.”  Clearly there can be Ws instead of Vs.

We will sum up.  The stock market may be in a V or it may be in a W.  We cannot tell.  There are favorable signs that support the March 9 low of 666 as the bottom of a V.  There are unfavorable signs that suggest this is a W and that after this rally another downward leg lies in our path. 

Our current strategy remains at about 50-50 stocks and bonds in balanced accounts.  We think the stock market has an upward bias in the near term.  We also believe that Treasuries are richly priced and should be sold.  Higher-grade corporate bonds and taxable municipal bonds are desirable.  Tax-free Munis are very cheap and are our most favored, risk-adjusted asset class for American investors in high income tax brackets.

Federal Reserve Independence

Last week the US Senate passed a nonbinding resolution urging that a review be conducted of the Federal Reserve Bank structure and costs and that the Fed disclose recipients of discount-window and other loans, the amount of assistance provided, and how the funds are being used. 

These populist actions against the Federal Reserve have a long history, going back to Congressmen Wright Pattman and Henry Gonzalez, who continually sought to limit the independence and powers of the Federal Reserve.  One of the costs to a central bank of its independence in setting monetary policy is that it also can serve as a convenient political “whipping boy” in times of economic stress.  The motives behind the current resolutions are no exception.  It is noteworthy that one of the sponsors of the resolution to open up the structure of the Federal Reserve for review is Senator Dodd, who is currently under pressure for a number of his actions, including the introduction of legislation that would have permitted the AIG bonuses, his role in helping push through the TARP legislation, and the sweetheart mortgages he obtained from Countrywide.  Dodd can’t attack his administration’s Treasury, but the Fed is fair game.  Poking a stick at the Fed is a way of deflecting public attention from one’s own problems.  This is an especially attractive strategy now, since Congress has experienced significant constituent backlash from the TARP program.  It was sold as a way to acquire bad assets and get them off bank balance sheets, but it quickly morphed into an embarrassing bank/Wall Street bailout at taxpayer expense.  Because of this strong reaction to the TARP and other costly rescue efforts, attacks on the Fed find willing allies among the members of Congress who now perceive they were stampeded by fear mongering into passing the TARP and are more than willing to try to pass the blame off on someone else.

The implications, however, of Congressional demands for increased Fed transparency on its loan programs go beyond the TARP episode.  They highlight the unintended consequences and threat to the Fed’s independence that are associated with its close cooperation with the Treasury and the proliferation of directed programs to support particular credit and asset markets.  Congress is now concerned that the Treasury-Fed alliance has subverted its budget and fiscal authority and is enabling the Treasury to circumvent the appropriations process by using the Fed’s balance sheet to expand the bank bailout process far beyond the initial TARP authorization, without asking for more funds.

Senator Sanders’ questioning of Chairman Bernanke at recent hearings clearly demonstrates how credit support programs create the demand for wider access to the funds on the part of consumers and businesses who sense that others are being granted access to subsidy programs not available to them.  They find willing champions in Congressional leaders for their needs. As Philadelphia Federal Reserve Bank President Plosser has pointed out, the expansion of the Fed’s lending programs have blurred the distinction between monetary policy and fiscal policy.  Such concerns would not have been an issue had the Fed followed the recommendations of Richmond Fed President Lacker and confined its emergency liquidity actions to expanding its purchases of Treasuries along the maturity curve.

The lesson here is that the broader the reach of directed credit programs using Federal Reserve resources, the more likely it is that the Fed will be subject to outside political pressures which can impinge upon its independence and may compromise its ability to conduct monetary policy.  This lesson not only applies to credit programs but also to micro-management regulatory responsibilities, such as consumer protection, truth –in – lending, and mortgage lending disclosures.  In addition, the more different responsibilities an agency may have, the more likely it is that goal conflicts may arise that may both compromise its monetary policy responsibilities and invite political intervention. 

The Fed has contributed to its own political difficulties by stonewalling Congressional attempts to determine the terms and identities of institutions receiving funds from the Federal Reserve.  The argument by Fed officials is that it is being transparent because it has posted program details on its website.  But these postings consist largely of technical documents and don’t provide meaningful information about program performance and thus have fallen on deaf ears.  The Fed’s principle argument for not disclosing the names of specific institutions or details on the emergency funding received, or how the money was deployed, is similar to its traditional arguments for not disclosing the names of discount window borrowers or bank examination ratings.  The concern is that the knowledge might cast a stigma on the recipients, causing customers to back off from doing business with them, or that, in the case of banks, it might cause a depositor run. 

This argument has been around for a long while.  Back in the ’50s and ’60s regulatory agencies refused to release bank income information on the same grounds.  There was special concern that if a bank reported a loss its depositors might run.  Since the early 1970s, however, bank income information has been publicly available, with no negative consequences even when losses are reported. In fact, such disclosure is now thought to enhance market discipline.  The Fed’s current concern may have had some validity before 2003, when access to the discount window was a privilege, was actively discouraged by the Fed, and was priced at a subsidy rate.  Then it was clear that taking advantage of the discount window was an admission of financial distress.  But presently, discount window access is supposedly limited to healthy institutions at a penalty rate and is intended simply to provide access to short-term liquidity and not to signal financial distress.  In the case of the emergency credit programs, policy makers went to great lengths to ensure that both distressed and sound firms participated; so revealing their names should confer no stigma.  But hiding a bad apple in a barrel of good ones usually doesn’t work.  Participation in the program, however, proved to be a costly decision for those healthy institutions that stepped up, who have subsequently discovered that the funds came with costly strings attached.  Furthermore, the program has also served as a cover for the regulators to engage in forbearance for troubled institutions.  The key current obstacle to disclosing the names of institutions receiving funding is the short-term one of managing the transition to a more open disclosure policy, which may actually be easier now than in the past. 

Maintaining an independent monetary authority is critical to the long-run health of the economy and to protecting the country from inflation.  The decline in the importance of the Federal Reserve Banks in check clearing and the failure to provide a substitute rationale for their structure, such as tackling the need to control identity theft, only provides additional fodder for outside scrutiny.  By opening itself and the structure of its system to Congressional interference, the Fed may have seriously put its independence at risk. 

Japan and the G20

The heads of state of the G20 countries are gathered today, April 2, in London for their meeting. Last week when I was in Paris, I was asked in a CNBC Europe interview if the upcoming meeting should be called a G2 meeting, with the US and China being the only important participants. Readers of the financial press could be excused for thinking that it will really be a meeting between three parties, the US, China, and the European Union. It was only yesterday when the presence at the G20 table of the second-largest national economy (at market exchange rates — third-largest in purchasing power parity terms), home to the second-largest equity market, received some press recognition.  That would be Japan.  The lead story in the Financial Times reported Japanese Prime Minister Taro Aso’s remarks stressing support for strong fiscal action by the major economies to counter the global recession and criticizing Germany for not understanding this. The lack of attention being paid to Japan probably reflects both the country’s current economic problems and the unsettled domestic political situation. International investors, however, should not ignore Japan.

The Japanese economy has tumbled into the most severe downturn in Japan’s postwar history. Japan did not have a bubble in its real estate markets.  Nor did its financial institutions appear to have excess leverage in their loan portfolios, nor heavy emerging-markets exposure. But crashing exports due to the global credit crisis and aggravated by a strengthening currency tipped the economy into the steepest decline of any major economy in the fourth quarter of 2008. GDP fell at a -12.7% seasonally adjusted annual rate.

The decline has continued in the quarter just completed. In February, Japan’s exports dropped -49.4% y/y, following a similar -45.9% decline in January. Industrial production in February was down a striking -38.4% in February from the year earlier. Yesterday’s release of the Bank of Japan’s so-called “headline” Tankan diffusion index for large manufacturers, a business conditions index, revealed a plunge to a record low of –58, from -24 in December. Japan is in a deep economic recession, with a return to deflationary conditions from which it had only begun slowly to emerge.

While this imported economic crisis could not have been avoided, the ability of Japan’s economic policy makers to respond has been hampered by the country’s domestic politics, which have been in a state of turmoil for several years. There have been three prime ministers since Koizumi stepped down in September 2006.  The ruling Liberal Democratic Power must face a parliamentary election by September. It appears to be doomed to defeat, and observers question whether Aso will be able to hold on to his position until the election. Efforts by the government to provide fiscal stimulus have encountered stiff resistance by the opposition Democratic Party of Japan, which controls the upper house of the Diet.  Nevertheless, the three successive fiscal stimulus packages introduced since August 2008 total about 2% of GDP. Prime Minister Aso said earlier this week that he has given instructions for a further economic stimulus package “based on bold thinking” to be developed before mid-April. The dimension of the plan is expected to be on the order of $200 billion.

Given the political inability of the government to act rapidly and effectively, the Bank of Japan, usually kept in the shadows, has moved to center stage and has taken some well-directed actions. Its competence reflects the fact that the BOJ has, in my view, the best economists working in Japan’s public sector. But the Bank’s independence from the government is more limited than is the case in most other major economies. Measures to provide liquidity include purchases of up to 3 trillion yen of commercial paper and 1 trillion yen of corporate bonds by September. The Bank will also be increasing its purchases of government bonds and of shares held by eligible banks.

Looking forward, the OECD, in its revised forecasts released earlier this week, sees a recovery in domestic demand in Japan coming only in the second half of 2010. They see overall GDP growth in 2010 at -0.5%, following a decline of -6.6 % for the full year 2009.

Japan’s equity markets, as measured by the MSCI index for Japan, dropped by -17.4% in the first quarter of this year. This was substantially greater than the -11.1% decline in the MSCI index for the US equity market. The decline in the MSCI index for all Europe also was less, -15.2%, but the Euro Zone’s decline was slightly greater at -17.8%.

While Japan’s domestic investors have continued to shun the market, some international investors appear to be starting to find valuations in the Japanese market attractive, despite all the negative factors noted above.  Should the Japanese yen weaken from its current high level (as seems likely to us) and the new fiscal stimulus program, together with increased quantitative easing by the Bank of Japan, be implemented and be successful in encouraging Japanese consumers and investors, the OECD’s projections could well prove to be too pessimistic.  To cite several other plus factors, Japan surely will benefit from the expected resumption of strong growth in China and the anticipated beginning of a recovery in the US in the second half of 2009.

At Cumberland Advisors our international portfolios currently have underweight positions for Japan.  We will be looking carefully for signs of an improvement in prospects there. However, for us the time to increase exposure to this important market has not yet arrived.

Heads or Tails? Parts 1 & 2 – Combined and Revised

Dear Reader: Please give me 8 minutes to explain the $1.1 trillion federal government Public-Private Investment Program (PPIP).

Start here with this simple example. It’s a coin toss. Heads you win $100; tails you get nothing. How much would you pay to play? You can play as many times as you wish. Answer: not more that $50. For less than $50 you would play as often as you can. $50 is your breakeven; only a fool would pay more.

Now add Tim Geithner as your partner. He matches what you invest but you, and only you, get to set the price to play. Answer: you put up no more than $25 as the investor and that means he matches your number. At under $25 you play as much as you can. $25 is your breakeven as the investor; $50 is still the breakeven for the coin flip.

Now let’s add some of the leverage from the FDIC.

Suppose that the FDIC will loan you $40 as a non-recourse loan. You and Geithner each put up $5 for a total of $10 and, adding in the loan money, you pay $50 to play, just as before. If you get heads, you pay off the loan of $40, and you and Geithner split the rest. That means you get $30 for your $5 and so does he. Remember, you set the price to play. If you get tails you get nothing and lose $5, Geithner loses $5, and the FDIC loses $40.

Now suppose we have an auction to decide who will play.

The highest bidder wins the right to play as many times as he wishes. With this example, the breakeven price rises from $50 to $70. At $70 you put up $15; Geithner puts up $15 and the FDIC still loans $40. Half the time you will win $100 and use $40 to pay off the FDIC, leaving $60 for you to split with Geithner. You will get $30 back for each $15 you play, when you win. The other half of the time, you will get zero, since it’s still a coin flip risk.

Notice that the price to play went from a $50 breakeven to a $70 breakeven. This happened while the odds remained a 50-50 coin flip.

Also, notice that the leverage ratio was low when you put up $15, Geithner put up $15, and the FDIC put up $40. Under the Treasury PPIP plan, the leverage ratio can go as high as 6 to 1. Using the full 6:1 leverage ratio, a coin-flip breakeven point would be about $6.25 for the investor.

Here is how I get that number. You put up $6.25; Geithner puts up $6.25; the total investor’s equity is $12.50. The FDIC loans 6 times or $75.00. Total price to play is $87.50. Each time you play you either collect $12.50 or zero.

Notice that the breakeven auction price is now $87.50 each time because you, as the private investor, are the one who sets the auction price. You are the only one who controls the bidding. Geithner is matching you and the FDIC is loaning 6 times the equity.

The leverage and the risk transfer have raised the investor’s breakeven from a $50 auction price, if you did this all by yourself and without any leverage, to a $87.50 auction price when leverage is fully deployed. The risk of winning or losing is still a coin flip.

Let’s substitute a toxic asset on a bank’s balance sheet for the coin.

Instead of a 50-50 coin flip, with PPIP we have a toxic piece of a mortgage-backed debt instrument that has an uncertain value. If we use PPIP, aren’t we really inflating the price artificially? It seems to me the answer is yes.

How can we adjust for this risk transfer that allows the auction breakeven price to rise? That answer lies in how much the FDIC will charge to make the non-recourse loan. If the FDIC charges enough, it will bring the auction price back to $50 and restore the deal to neutrality. If the FDIC charges more, it will bring the price below what it would be without the leverage.

But if the FDIC underpriced the loan cost, it would then have subsidized the deal and allowed the auction price to rise. That means the seller of the toxic debt instrument got more than it was worth and the investor made a profit because of the FDIC.

Some of the risk of payment on that instrument transferred to the FDIC. That means it transferred to the FDIC insurance fund, which means it transferred to every insured deposit in every bank that pays an insurance premium into the fund. That means the depositor may be getting a lower interest rate on that deposit than he otherwise would get.

That is PPIP.

Some Questions. Will this process set a true “market price” for these toxic assets or are we using a gambler’s pricing mechanism? Has Geithner been transparent about this risk transfer to the FDIC? What will the FDIC charge investors when it assumes the 6:1 leverage risk? Will it price risk fairly or will it grant massive subsidy to banks?

Dear reader: you decide if this is a good thing or a bad thing. You decide if this is how it was presented to you. You decide if this is a sound policy solution for the US banking system or if you believe that, our government has taken “moral hazard” to a new level with pee-pip?

For more details on PPIP see this weekend’s issue (March 30) of Barron’s and the columns on PPIP by Jonathan Laing and Andrew Bary. They start on page 25 and offer an investor’s view. As a money manager for our clients, the Cumberland firm will look at PPIP and may use it on behalf of clients after we have reviewed an official form of an offering document. As a private citizen concerned about my country and its policy direction, I think this reeks and stinks.

Heads or Tails? – Part II

We thank readers for their responses to our “Heads or Tails” commentary, dated March 29, 2009. Many issues were raised. We will use this Part 2 to address some of the items and correct technical errors or lack of clarity in our first missive.

First, let’s offer a recap and explanation. In Part 1 we used the metaphor of a coin toss to depict how leverage works to raise the auction price of assets. Six to one leverage is the maximum under PPIP. We used it to dramatize the volatile effect on the auction price. Some components of the PPIP are likely to have much lower leverage ratios. We also argued that the transfer of risk to the federal government is the mechanism of the PPIP. We pondered whether this process actually will result in an artificially inflated transaction price. The financial market reaction to the announcement of PPIP suggests that it will. Lastly we questioned whether this is a sound policy prescription for the United

Technical and clarifying points follow:

1. PPIP is divided into two categories. The first deals with loans on the books of banks. The second deals with securities held by banks, insurance companies, and others. Treasury calls both “legacy assets,” but it is important to note that the programs dealing with each of these two categories differ in construction and leverage.

2. The FDIC is involved in the loan program. It doesn’t lend directly; it acts as a guarantor and receives a fee. The pricing of this fee is critical, as we outlined in the first commentary. At this writing we do not know what the pricing mechanism will be. The FDIC is asking for comments, as readers can find for themselves at . A full description of “legacy loans” is available.

3. The Federal Reserve and the Treasury are the financing sources of the securities category. A more detailed description is available on the Treasury website at This is the March 23, 2009 press release. Several links at the bottom direct interested readers to the details.

Some thoughtful responses to Part 1 are reproduced below. We are withholding names of all writers, since some have asked for anonymity.

From a seasoned and skilled broker who has special expertise in bank stocks:

“Those institutions that have marked both loans and investments properly will have capital added to their balance sheets as they sell: let us hope and pray that is the majority of them. By the way, one might conclude that it is a good time to buy those stocks aggressively, as they benefit handsomely from this plan. They may even be able to mark up their remaining assets as market pricing improves. Could you imagine book values growing from this? Stranger things have happened.”

“Those institutions who have not priced their assets ‘to market’, but are still in the ‘ballpark’ (forgive me, baseball is upon us) will get bailed out as leverage encourages higher prices, and that may not be all bad as their balance sheets are cleansed. One can speculate that fear may have driven down some of these prices to levels that are penurious at best. This assist may let assets clear the markets at more realistic levels, whatever that means. “

“What are the prices going to be? Will the banks really sell assets or will they be too afraid to test the waters? In many cases their investment securities are marked to market, but how about their loans? Price realization in that area has me concerned, but I am hoping that once this logjam gets moving it will adjust quickly, as participants don’t want to miss this one. So many questions!”

“Understand I am just speculating here, as I have never seen anything like this — but I sense a real opportunity here.”

From a former Federal Reserve official, about the theoretical breakeven point:

“The FDIC isn’t lending the money, but rather the buyer has to issue debt. The cost of the debt and the cost of the guarantee will make its price critical. This should trade like Treasury debt, I believe; and if it does, then the fee and interest costs will have to also be shared between the investor and Treasury, which will lower the breakeven point. They haven’t decided on whether this debt is tradable or not. If it isn’t, then it will bear a higher interest rate than treasuries for liquidity reasons. Also, it will compete with Freddie and Fannie debt and also with the flood of Treasury debt that will come on the market. In the end, won’t there be moral hazard as the investors who have to be sellers of the debt to finance the program bid up the interest rate they are willing to pay to get a share of the market, which will exacerbate the price discovery mechanism and lead to overpayment for the assets in auction?”

From a prominent law school professor:

“Your concept did come through, and it was a very good way of explaining it. It’s just that the loan/securities distinction means little to most casual observers, but is really big. It also shows how the government has spun this. The loan program is open to anybody and has 85% financing.  The securities program will be handled by 5 managers and they must each have 10bb of MBS under management. And, most of what are called “toxic assets” on balance sheets are securities not loans, so the latter program will by necessity be bigger and the discounts larger. So the best opportunities in this deal may well be only for the very institutions that are so often blamed for how we got here. But by making it seem that the loan program is equal, and emphasizing it, the administration is able to make the whole thing seem much more egalitarian than I suspect it is. Pardon if my cynicism is showing, but I am not a big fan — as a citizen — of the program. As a businessperson, if we can figure out how to play in the sandbox, we will try to have a lot of shovels and a sturdy bucket.”

From an insurance executive:

“A traditionalist would hang on dearly to the ‘good’ in the financial world, wanting to believe that the world as we know it is not “The Matrix” or the Mother of All Ponzi Schemes (MOAPS, to stay in tune w/ the government’s acronyms). A New World theorist would comment that this is all part of the plan to dismantle the US and level the playing field. The theorist believes that the Obamas and the Geithners of the world aren’t who we think they are, but have been ‘bought’ to play their part in the plan. Unless you ask me to cease and desist, as a patriotic American (which I imagine we both are), I will continue to stay in touch as we observe the gradual erosion of the America we once knew when we were younger.”

From a seasoned investor with skills in the mortgage arena:

“The current idea floated by financial institutions, and the media in partner with them, is that these derivatives may actually come back in value. That cannot and will not happen for very concrete mathematical reasons. “

“A CDO built in 2005 is almost certain to contain mortgages written with 105% financing with 50% DTI. Those loans are blowing up at enormous rates. Hence, since the CDO’s return is predicated on nothing more than a positive flow from the underlying securities, every tranche containing blown mortgages exceeding the modeled margin of default is a 1000!o loss. “

“Underwriting guidelines have almost returned to sane levels. The banks are lending, but the new guidelines limit those that are lent to. That has eliminated more than 50% of the possible buyers which existed 3 years ago.”

“The only way for any of the CDO’s, CMO’s or CLO’s to retain any value is if housing values go back to where they were in Jan 2006, and soon, before any more mortgages in the underlying MBS go into foreclosure. “

“My point is this: even the conduits are a time bomb, which will realize near 100% losses, unless housing values dramatically rise, right now, so no more houses (mortgages) in the MBS go bad, and give the current mortgagees a way out through sale for profit or true refinance. “

“Every credit derivative based on obscene underwriting guidelines will eventually be a near 100% loss. For that to be different, we need to let as many people back into the buying market as were present then, to put upward pressure on housing values. “

“The only way to do that is to adopt, again, obscene underwriting guidelines. Because that will not happen, any and all monies given banks to cover losses with credit derivatives will be a total loss. I believe it is better the banks assume the loss. There are several hundred middle-tier banks with no credit derivative exposure, and little residential or commercial RE exposure. They can and will fill the void should some “big brothers” go by the wayside. “

“The PPIP is nothing but a shell game, and will drag this country somewhere no one wants to go.”

From a stranger known only as JPM:

“Your explanation assumes that the buyer and seller are unrelated and have no association. If they have related interests, then it gets much much worse.

“There is nothing substantive in the Treasury Dept language that prevents the seller of (say) MBS from creating an “unrelated” third party, who can then compensate the buyer for bidding face value of the assets. The PPIP is so easy to game it ought to be DOA.”

From a regular Cumberland reader who gives a jet-lagged writer some comfort and strength to continue:

“This analysis couples with John Hussman’s article regarding the potential abuses of the PPIP — namely that sellers of the ‘legacy assets’ are actually allowed to bid on their paper or the paper of other sellers, opening the door for all sorts of conflicts. Where are the checks and balances of this auction process? Once again, the US taxpayer is going to get left holding the bag as the banks that created this mess get a ‘Get Out of Jail’ card for free. This is going to end in a disaster, as a massive transfer of wealth is happening right before our eyes. I for one am writing to all the Congressmen/women who have the wisdom to see the folly of this plan. “

“For your part, you nail the conundrum squarely — as an investor you see a tremendous opportunity to make money with the risk/reward balance tilted severely in your favor. As a citizen of the US, you see a tremendous burden being placed on the taxpayer and future generations of Americans. Time will tell which path is taken.”

We offer this from a hawkeyed reader who embellished the math:

Mike wrote:

“When comparing this auction price to the hypothesized fair value of the unleveraged bet of $50, there is a $37.50 premium induced by the leverage. Alternatively, the owner of the asset with a $100 nominal value takes only a $12.50 haircut in the auction.”

“A perhaps more realistic example, however, would be to suggest that the asset might have a value of $100 or $80 with a 50% probability of either result. In this case, the fully leveraged breakeven point is $6.43 for the private investor, $6.43 for the Treasury, and a FDIC loan of $77.16. In this case the payoffs would be $22.84 if the asset was worth $100 and $2.84 if the asset was only worth $80. The fair value of this coin flip bet is $12.84 (within rounding of the equity portion of the purchase price) and the auction price would be $90.02. This auction price is almost exactly the fair value of the original bet $90.00 and the owner of the asset takes a haircut equal to the full difference. I think this example shows that in the case where the nominal and worst case values of the asset are closer together, the leveraged auction will produce a reasonably equitable result.”

“The difference in outcome between these examples lies with whether the FDIC takes a loss on its loan. This occurs when the worst case value falls below $75 in this coin flip world. As long as the equity partners are not exposed to a loss in the worst case, the breakeven private investment amount will remain $6.25 and there will be a premium paid above the fair value of the asset.”

And this is from an expert in a ratings agency:

“I work in a small group in (name withheld) that focuses on the capital markets, and I have followed your firm for–well, about 100 years.  Some of you (the older ones) might recognize my surname and know why.”

“I agree with Mr. Kotok’s assessment of the PPIP.  Actually, if you look at the Treasury’s statement, there are a few interesting things to be gleaned from it–at least in my opinion.  First, on “legacy securities”, it looks like they finally got Pimco’s and BlackRock’s agreement on the terms they would accept and will now allow 3 more firms to bid as long as they can get their applications in by April 10th.  Given the “eligible securities” (originally rated AAA, collateral has to be connected to securitization), I can’t imagine that much will actually trade hands because it looks like the asset managers were looking for the “lay-ups”–the RMBS that are performing quite well, thank you very much.  Prices may not be great, but cash flows are still coming through.  What bank wants to sell those?  I would buy them without leverage from the Treasury.  CMBS prices are terrible, but underlying asset prices are soon to follow, so prices reflect collateral, not liquidity discount.”

“But on “legacy loans”, different story entirely.  First, check out the different type face.  What?  Is the Treasury talking with two voices?  This was not limited to 5 managers, and, reading between the lines, they were going to be willing to be a lot more flexible on terms.  They are desperate on whole loans.  They see the problem (I go to the FDIC failed bank list every Friday), and they see the problems coming.”

“On all of this, yes, I think the government is taking, has taken the wrong approach.  My biggest beef was paying face on the CDS contracts from AIGFP, but that was not the issue here.  I think there is enough revulsion from many quarters, financial and even non financial, that we are close to the end of this.  I certainly hope so.”

Systemic Risk Authority

Momentum appears to be gathering to establish a systemic risk authority and grant to it the powers similar to those available to banking regulators to resolve troubled institutions that may pose systemic risks to the financial system and to the economy.  Chairman Bernanke and Secretary Geithner, as well as other banking regulators, have asserted that the lack of such authority was a major reason that the government was faced with the either/or option of either a disruptive bankruptcy or a government bailout in resolving Bear Stearns, Lehman Brothers, and AIG.  This stands in sharp contrast to how the FDIC insured financial institutions Countrywide and Wachovia were resolved.  The negligible market reaction and lack of negative externalities associated with how these latter resolutions were handled were striking when compared to the fallout from the Bear-Lehman-AIG scenario.   Reliance upon the general bankruptcy statutes, as we do for non-banking firms (and as Europe and most other countries do for both banks and non-bank firms) involves uncertainty for creditors and lengthy delays to access funds and services before business can be resumed.  This uncertainty and its costs create incentives to deny funding and pull business from troubled firms and can generate significant market disruptions. 

There are, however, two critical issues that must be confronted as Congress contemplates granting new resolution powers and systemic risk responsibility to the Treasury, Federal Reserve or to some other authority.  The first is the need to clearly specify the criteria to be used to identify those institutions ex ante as to which bank-type failure resolution procedures should apply.  This will truncate uncertainty about the status of debt claims and the ability to conduct normal business so that creditors and customers know in advance the risks and potential delays they may be subject to in the event the firm they are doing business with or are funding should get into financial difficulties.  The criteria should specify how and when to exclude institutions from coverage whose size or activities no longer warrant treatment under special bankruptcy procedures. Without such a set of rules, the authority will simply be a wildcat agency whose actions or lack of actions will only enhance market uncertainty.

The second issue is to recognize that there are practical limits, especially in the case of large financial conglomerates, to the ability of the US government to grant any regulatory body the authority to close or resolve an institution with multiple subsidiaries and affiliates chartered in many different legal jurisdictions and countries.  NY Fed President Dudley summarized the problem well in his recent testimony before the House Financial Services Committee when he described the difficulties Lehman Brothers and AIG presented to the government:

In the case of Lehman, some of the most severe repercussions related to the difficulties in coordinating cross-border insolvency regimes and in coordinating the insolvency regimes among different types of institutions within the organization’s corporate structure.  In light of AIG’s unparalleled global footprint – operating in more than 130 countries around the globe – and the multiplicity of different types of financial services entities within its structure – including insurance providers, foreign banks, consumer lending companies and OTC derivatives affiliates – the factors that proved unmanageable in the Lehman insolvency threatened to be much more severe in AIG’s case. The fact that no effective emergency resolution procedures exist under U.S. law to reconcile these difficulties heightened the need for quick, effective action by the Federal Reserve, in consultation with and supported by the U.S. Treasury.

In addition to President Dudley’s points, however, is the fact that the US government has no legal authority to grant any regulator the power to close affiliates and subsidiaries of US conglomerates chartered by other sovereign states nor to ring fence or to claim jurisdiction over assets owned by those foreign chartered entities.  These are not new problems and have surfaced before in the BCCI failure, but have yet to be addressed satisfactorily. 

It is simplistic to suggest that lack of legal authority was the prime barrier to resolution of Bear Sterns, Lehman Brothers and AIG.  It clearly was a factor, but the same problems would exist for the FDIC to deal with JPMorgan Chase or any other large banking organization.  Wachovia, Wamu and Countrywide were relatively simply cases because the bulk of their assets were in US chartered banks, subsidiaries and affiliates.  This simply wasn’t the case with Lehman Brothers or AIG.  It is also not likely to be the case for other institutions that might possibly be designated as systemically important institutions and subject to the new regime.  In fact, such institutions are even more likely to conduct business through foreign-chartered subsidiaries and affiliates in order to protect certain assets from the new resolution procedures. 

Fair questions to ask Secretary Geithner and Chairman Bernanke, who are urging the granting of new resolution powers are:

  1. Exactly what powers would you have needed to deal with AIG differently and what would you have done? 
  2. How would you have dealt with the foreign subsidiaries and what proportion of AIG’s resources would have been out of reach and/or potentially at risk because of inter-company dealings through its securities lending and derivatives activities?
  3. Would the procedure have enabled the separation of AIGFP from the rest of the company at that time?  What would have happened if the entire AIGFP operation had been headquartered in the UK instead of only part of its operations?

We could learn a lot through a careful forensic investigation of the AIG, Bear Stearns and Lehman Brothers cases, which might aid in structuring any changes in regulations and resolution authority.  Those investigations should proceed before there is a rush to re-regulate. 

In the last day, Secretary Geithner has now proposed that resolution powers be shared between Treasury and the FDIC specifically, and perhaps with the Fed in some way as well.  This is merely shifting of responsibilities but does not address the specific powers, authorities and funding that would be needed to make such an authority an effective contributor to financial stability.  In addition, discussion also seems to be coalescing around the idea that the systemic risk authority might even have prior approval and/or the ability to determine the suitability of certain financial instruments and financial innovative products for customers like the Food and Drug Administration has for medicines.  Should that responsibility be given to the systemic risk authority or any other governmental body, then the US financial system will surely fall to the bottom of the heap relative to financial markets in the rest of the world.

A Lynch Mob

“Let’s go hang ‘em.”

American history is replete with examples of lynch mobs taking control of a situation and inflicting injustice.  In the end most lynch mobs have dealt harmful blows to society.  Congressional action to punish AIG employees over the bonus issue is already seeding that outcome.

Members of the US House of Representatives who voted for this bill said they were reacting to the anger of their constituents.  In failing to show leadership they have just undermined the entire structure designed to repair the financial system.

Specifically the House did the following:

1.  They licensed the abrogation of contracts.  Their message is simply that it makes no difference what rules we put into effect now; we can and will change them so you cannot depend on them.  Global businesses take heed:  Your previous judgment about the sanctity of US law has been rendered faulty by our political leadership.

2.  They passed retroactive taxation.  Their message is that, whatever you plan with regard to the federal tax code, do not assume consistency and do not build any reliability about your government into your decision making.  We, in Congress, can reverse our laws and confiscate your results.

3.  They made the tax punitive.  A 90% tax on something is like taking all of it.  The chairman (Rangel) of the House taxation committee actually admitted that by taxing the 90% he was leaving the remainder for the states.  In other words, states are now encouraged to engage in the same form of behavior.

Sure citizens are outraged over the $165 million in bonus payments to AIG staff.  But they should direct their outrage at the Congress and not threaten the employees or their families with personal injury.  The Congress authorized these payments; Dodd, Geithner, and Obama Administration personnel admitted that.  Remember, the law passed without giving anyone the chance to testify in public hearings and without allowing comment on the draft legislation.  When the law originally went through the Congress, the House leadership suppressed amendments.  This Barney Frank and Nancy Pelosi-led House is especially guilty of ignoring the rule of law.  They are now guilty of encouraging the rule of lynch mob.

The result of this House action is already damaging.  The federal regulator of Fannie Mae and Freddie Mac has shown the courage to ask that this law not be advanced in the Senate.  We expect to hear more from those federal personalities who have the strength to speak up and oppose this House-approved proposal.

But depending on the Senate to soften the law or depending on the US Supreme Court to overturn it is a dangerous strategy.  Some Congressmen admitted privately that they voted in favor because of constituent pressure, even though they were really opposed to the concept.  They voted “yes” because they were relying on the Senate or the courts to say “no.”

Some damage is already done.  Firms that were gearing up to participate in the federal program to be announced this coming week are considering withdrawal.  They fear that any action which puts them into the federal assistance plan will subject them to the chance of retroactive punishment and taxation.  The House has undermined the so-called public-private partnership designed to help restore financing of consumer items like automobiles and credit cards.  We expect that the participation in the program to be announced this coming week will be tepid at best. 

At Cumberland, we are advising institutional clients to take great care when engaging in any form of activity with the federal government.  Simply put: a lynch mob can turn on you in a second and cannot be trusted.  The risk is now very high. 

Other firms that are already acting with TARP monies, or other federal monies for that matter, are seeking ways to deleverage and exit.  In the entrepreneurial and risk-taking business and financial community the universal response to this act by Congress is outrage and distrust and disgust.  

So far President Obama is silent on this lynch-mob approach.  He has yet to declare himself against it. 

Obama needs to be reminded of a parallel in history.  A century ago a man named Leo Frank was lynched in Georgia for a murder he did not commit.  Local politicians supported the lynch mob; those courageous politicians that opposed it were voted down.  Frank was an innocent victim.  His subsequent posthumous pardon did not undo the harm. 

A century later a man named Barney Frank brags about the earmarks he obtained for his Congressional district (see his website).  This modern Frank foments the modern-day version of a lynch mob.  The House of Representatives and the Financial Services Committee under the leadership of Barney Frank have made the first day of spring 2009 a sad day for America.  They suppressed the rule of law; they chose the rule of the lynch mob; they are now going to have to live with that result.  

When the citizens of America realize what the House has done, they may redirect the lynch mob against the Congress.  That is coming next.  As Yogi Berra said: “It ain’t over till it’s over.”

We fly to Europe in a few hours and will chair the Global Interdependence Center delegation at the Paris conference next week (see ).  Meetings will include central bankers, global investors, and businessmen.  Our private roundtable will now also address this House action and what it means for US policy and American markets.  Current scheduling from Paris includes CNBC on Monday at 10 AM New York time and again on CNBC on Tuesday morning at 5 AM New York time. 

An Interesting Hearing: AIG – Part One of Three


Representatives from the Federal Reserve, Office of Thrift Supervision, and New York State Insurance Department testified on March 5th before the Senate Committee on Banking, Housing, and Urban Affairs. They reported on what went wrong in AIG and explained the Federal Reserve and Treasury’s $170 plus billion support of AIG.  The description of the government’s support of AIG is terse, but a careful reading raises a number of questions about AIG, its operations, and how the institution was supervised and regulated.  In this three-part commentary, Part 1 attempts to briefly describe what went wrong in AIG.  As will be shown, the problems were not primarily related to its derivative contracts, and in particular, its credit default swaps.  Rather, the problems were much broader and were a function of its concentrations in real estate investments.  Part 2 looks at the regulatory and supervisory environment surrounding AIG, the assertions that there was no consolidated supervision of the entity, and where the money went.  Part III looks at the systemic concepts that were employed to provide financial support to AIG, and it poses questions that the whole case raises when it comes to the need for additional transparency and authorities for rescues of large firms by government entities.

Background on AIG’s Structure

The impression one gains from previous statements about the government’s support of AIG is that it was necessary because of systemic risk (which was the focus of a recent commentary by David Kotok and will be explicitly considered in Part 2).   But, there has been little discussion and few details provided about the size or sources of AIG’s problems.  The hearings and testimony provide some information, but AIG’s annual reports are much more specific.  Here is a brief run-down on what AIG was doing and what its problems were.

AIG was a large, complex insurance conglomerate with three main lines of insurance activities (general insurance, including property and casualty insurance; life and health insurance and retirement products; and asset management) and a financial services business.  The company had about $1 trillion in consolidated assets and operated in about 140 countries.  It had more than 71 insurance companies based in the US and over 175 other financial services companies.  Under the US’s McCarran-Ferguson Act, AIG’s insurance businesses were regulated by the individual states where it was licensed to operate.  As such, there is no one insurance regulator or a federal regulator responsible for AIG’s insurance activities.  However, AIG became a Savings and Loan Holding Company in 1999, and owned three federal savings banks.  AIG was thus subject to consolidated supervision by the OTS, and this also included its Financial Products Group (AIGFP).

What Got AIG into Trouble?

Despite the public focus on AIG’s credit default swaps as the main source of its financial difficulties, they were only a small part when compared to two other problem areas – but first, the credit default swaps.  AIG’s main swap program was conducted through AIG Financial Products (AIGFP).  As of year-end 2007 (see AIG’s 2007 annual report, pg. 122) the company had $527 billion in outstanding swaps in its “super senior credit default portfolio,” which were swaps that placed AIG senior to the risk layer rated AAA or the equivalent thereof.  About 44% of these were swaps written on corporate loans, 28% were written against prime residential real estate mortgages, and 13% were written against corporate debt.  Approximately 72% of its swaps were written on behalf of European institutions to facilitate avoidance of Basel I capital constraints, rather than mainly for risk-management purposes.  In fact, the company even categorized these swaps as “regulatory capital” to indicate the purpose for which they had been written.  About 15 percent ($78 billion) of its swaps were written on so-called multi-sector Credit Default Obligations (CDOs), of which $61.4 billion contained some exposure to subprime mortgages.  What made the swap business attractive was that AIGFP was able to trade on AIG’s AAA rating and write the swaps without necessarily having to post collateral against possible losses on the swaps.  In many instances, however, AIG also included “triggers” in the swap contracts that obligated AIG to put up collateral if it should suffer a downgrade.  It did so because the trigger clauses generated extra fees at what appeared to be zero risk to AIG. 

In the 4th quarter of 2007, the value of the multi-sector CDOs against which the swaps were written began to decline (because of their heavy concentration in subprime mortgages), requiring AIG to write down the associated valuation losses of about $11.1 billion.  Note that AIG wasn’t experiencing losses due to failure of the underlying securities.  Nevertheless, AIG’s auditor, Price Waterhouse Coopers, forced AIG in its SEC Form 8K to indicate the presence of material weaknesses in its valuation and control processes related to AIGFP’s activities.  Throughout 2008 AIG’s financial condition deteriorated, and finally the government stepped in and provided the first of several bailouts.

By year-end 2008, although most of AIG’s multi-sector CDO-related swaps had been terminated under agreements with the Federal Reserve and Treasury as part of its rescue commitments, AIG still experienced another $25.7 billion in losses, in addition to those suffered in 2007, associated with its multi-sector CDO swaps.  The annual report also indicates that the collateral requirements in connection with that portfolio were relatively small.  Finally, the Senate hearings and the OTS representative made it clear that AIG’s multi-sector swap business wasn’t an ongoing activity, but rather AIG had made the decision to stop writing them in 2005 as the housing market began to show signs of slowing.  As a result, the program and its losses were a legacy of previous bad decisions that had not yet worked themselves off AIG’s books.

The losses from its swap program were small in terms of their impact upon AIG compared with two other activities.  In particular, AIGFP ran a securities lending program, in which it lent out securities that AIG had acquired, mainly in connection with its insurance reserves, to counterparties in return for cash.  The proceeds were then used to purchase what turned out to be high-risk RMBS (Residential Mortgage Backed Securities).  This effectively means that AIGFP was running a thrift that borrowed money short-term and invested the proceeds in long term mortgage debt.  Only in this case the funding was anywhere from overnight to at most two weeks, whereas the maturities of the RMBS were often measured in years.  Again, AIG’s 2007 annual report indicates that about 14% of AIG’s total liabilities consisted of such borrowings, which is a huge amount for an insurance company.  At year-end 2007, the company indicated that it had about $75 billion in assets lent under this program, of which about 80% had been supplied by its US domestic life and retirement services businesses.  In total, AIG’s holdings of RMBS were nearly $90 billion. 

When problems appeared in its mortgage-backed securities portfolio, AIG experienced in 2008 what was characterized as a liquidity problem, in that it was unable to purchase back the securities it had lent out for cash.  While this looked like a liquidity problem, it was really a solvency issue.  AIG could have sold securities (an in particular the RMBS) but didn’t want to take the capital losses that would have been required.  If an institution has losses on an asset portfolio, then that portfolio declines in value and those losses have to be recognized and written off.  But AIG wasn’t only experiencing problems in its RMBS portfolio.

The third area of difficulty for AIG was in its overall investment portfolio.  In 2008, AIG had experienced capital losses of nearly $ 55.5 billion on its assets, in addition to the $28 billion in valuation losses on its swap program mentioned earlier.  These investment losses swamp the significance of AIG’s derivatives losses.  Finally, it should be noted that for the year 2008, AIG reported a net income loss of $99.3 billion, of which about $62 billion occurred in the fourth quarter after government support had been put in place.  The asset valuation losses were more than covered by premium and investment income, but benefits and claims paid to policy holders and policy acquisition fees (the normal expenses of any insurance company) and interest expense (including $10 billion in interest paid to the Federal Reserve for its loan) resulted in the huge loss.


The picture that emerges is that AIG was engaged is very risky operations with significant lines of businesses that were heavily dependent upon various segments of the real estate market.  Its multi-sector CDO swap business was real estate-related.  Its securities lending business was real estate-related and also took significant funding risk by borrowing short and lending long, and its overall investment strategy was also heavily dependent upon real estate.  Interestingly, all three parties at the Senate hearings chose to emphasize AIG’s securities lending programs and credit default swaps and paid less attention to its overall investment strategy per se, of which these two programs were both clearly significant but only part of the problem. 

In Part Two of the discussion on AIG, we will focus attention on the regulatory and rescue efforts, with particular attention to what we know and don’t know about the quality and dimensions of AIG’s supervisory oversight and the extent to which its failure might have constituted systemic risk.  It also attempts to sort out where the money went.  Part III looks at the systemic risk issues.

An Interesting Hearing: AIG – Part Two of Three


Representatives from the Federal Reserve, Office of Thrift Supervision, and New York State Insurance Department testified on March 5th before the Senate Committee on Banking, Housing, and Urban Affairs and reported on what went wrong in AIG.  Part I of this commentary explored the nature of AIG’s financial difficulties.  AIG’s problems were much deeper than simply its having issued credit default swaps or having a short-funded investment in RMBS built upon its securities lending program.  It also suffered write downs in its holdings of other real estate investments that were substantially larger than its swaps or RMBS holdings.  In this Part II we consider the supervisory responsibilities for AIG and the government’s response to AIG’s problems.  In other words, where the money went.  In Part III the systemic risk rationale for intervention in AIG is evaluated.

Was AIG or Wasn’t It Subject to Consolidated Federal Supervision?

The NY State Insurance Department representative’s testimony specifically indicated that he was only responsible for AIG’s insurance activities, which accounted for only about 10 of AIG’s 71 US insurance companies, and that he was not responsible for AIG’s other activities, especially AIG Financial Products (AIGFP).  Interestingly, Federal Reserve Vice Chairman Kohn asserted before the same committee that: “Financial Products is an unregulated entity that exploited a gap in the supervisory framework for insurance companies and was able to take on substantial risk using the credit rating that AIG received as a consequence of its strong regulated insurance subsidiaries” (see Kohn 2009). A similar statement was made by Chairman Bernanke before the Senate Budget Committee that AIGFP was an unregulated entity.  The impression from these statements, as well as from Chairman Bernanke’s speech before the Council on Foreign Relations, was that there was a need for a consolidated supervisor for large, “systemically important” institutions to avoid AIG-type problems in such institutions. 

However, as was clearly stated in testimony by the Office of Thrift Supervision (OTS) representative, AIG had been a Savings and Loan Holding Company since 1999.  Therefore, the OTS was its consolidated regulator in the US.  OTS was also recognized as AIG’s consolidated regulator by the international community.  OTS’s Polakof testified that OTS participated in a number of meetings of the college of supervisors concerning AIG, that yearly international meetings had been held by AIG’s various supervisors, and that OTS had examined AIG.  Furthermore, OTS had also specifically looked at and commented to AIG’s board on the risky activities that AIGFP had embarked upon.  While AIGFP may have technically been an unregulated institution, it certainly was supervised as part of OTS’s consolidated supervisory responsibilities; and it is not clear what loopholes it exploited.  Because of this, several questions naturally suggest themselves.  First, was the Federal Reserve unaware of the OTS’s responsibilities, or did it simply regarded OTS as ineffective and irrelevant?  (This view would not be unreasonable, given that the OTS also gave us Countrywide, IndyMac, and Superior S&L, just to mention a few failures of regulatory oversight.)  Did the Federal Reserve request information from OTS about AIG and seek access to the examination reports prior to the Federal Reserve and Treasury intervention and bailout of AIG?  Why wasn’t OTS, as the responsible federal regulator, a party to the discussions that the Fed and Treasury had with AIG, as the options for addressing its financial difficulties were discussed?

Where Did the Money Go?

Various numbers are being thrown around concerning the amount of money that the government has channeled to AIG.  The highest number so far is $170-$180 billion, but where did the money come from and where did it go?  It is virtually impossible for anyone except perhaps an accountant to decipher the trail of changing funding commitments and modifications in preferred stock, equity grants, lending facilities, and transfers of interests in special purpose vehicles that have deeply entwined the Fed and Treasury with AIG.  Certainly, one can’t easily get that information from either the Fed or Treasury in an easily understandable form without having to dig though a host of arcane legal documents.  With some work, however, one can at least make a start by sifting through AIG’s 10Q for 2008, its notes to its financial statements for 2008, and the data released over last weekend on payments that have been made to counterparties.  Below is a first attempt to reconstruct approximately where the money is coming from and where it has gone so far.  The exact details of each transaction are not always very clear, and the process cries for a more complete, cumulative, and consolidated presentation of the support provided.


The extent of the benefits from the government’s support of AIG has generated great interest as the result of the AIG hearings and its subsequent release of the names of the counterparties who received payments.  It appears that much of the funds were actually paid out to creditors and counterparties, which means that they, and not AIG’s shareholders, have been the principle beneficiaries to date.  It is not easy to tell, however, what prices were paid for the assets exchanged, how those prices were arrived at, or what prices were employed in determining the payouts to counterparties.  The inference from some of the numbers and narrative in AIG’s annual reports is that market prices were used and not par value prices; but at the hearings some of the Senators suggested that counterparties may have been compensated at par, and none of the participants offered a different view.  Again, this is an area where better disclosure and transparency on the part of the government would clarify misconceptions and confusion. 

One side issue that immediately arises is that the payments to counterparties may have put certain creditors ahead of others by virtue of the government’s rescue, and that this would not have happened had AIG been placed in bankruptcy.  Whether this will constitute a “taking of property” may end up being resolved by the courts.  The list of beneficiaries of those payments is a who’s who of Wall Street and international banking.  Below is a list of the beneficiaries of the flow-through of US government support to the more significant of AIG’s counterparties.  Over half the funds went to five institutions: Goldman Sachs – $12.9 billion, Bank of America (Merrill-Lynch) – $12 billion, Societe Generale – $11.9 billion, Deutche Bank – $11.8 billion, and Barclays – $8.5 billion.  One of the largest is Goldman Sachs, whose president reportedly was the only nongovernmental representative (presumably as an advisor) at the initial meetings when the first bailout of AIG was put in place.


AIG may have been a rogue institution that engaged in risky behavior, but it was not outside the scope of the federal regulation of major financial institutions.  Its insurance activities were supervised on a fragmented basis, but it was its investment policies and not its insurance contracts that were at the root of AIG’s problems.  Because of its status as an S&L Holding Company, AIG was also subject to consolidated supervision as a whole entity by the OTS, and this included its foreign as well as domestic businesses.  It chose to ignore or delay responding to the OTS examination recommendations on its risk taking, and one can argue that OTS was ineffective in discharging its responsibilities.  As for the money, government money went principally to bail out AIG’s counterparties, but the exact details of those transactions are fragmentary, difficult to put together, and not particularly responsive to the public’s need and right to know.