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.

An Interesting Hearing: AIG – Part Three 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. Part II looked at the supervision of AIG and attempted to piece together where the money went. In this final part, the government’s rationale for intervening in AIG as a systemically important institution is examined and questions are posed that should be considered by the Congress as it considers financial reform proposals.

Where Was the Systemic Risk?

The concentrated nature of the payments that have been made to counterparties that were detailed in Part II of this commentary naturally raises the question whether the interrelationships among these few firms, combined with the fact that all but one of the top five recipients were also primary dealers, was the main reason that the Fed and Treasury stepped up in the AIG case.

More broadly, because of the interest in installing a systemic risk regulator in the US, the challenge is to devise an operational definition of a "systemically important institution" that is robust and dynamic and that could be used to identify when and under what circumstances government intervention in the affairs of a private-sector financial institution would be justified. This issue was touched upon in my colleague David Kotok’s recent Commentary, in which he pointed out the vague nature of the current public discourse on systemic risk. He characterized the present approach as one of "knowing it when you see it."

Because the financial costs of intervention can be great, both in terms of pecuniary costs and the potential for moral hazard, it is important to have a definition that can be consistently applied, regardless of who is in charge of the Treasury, Federal Reserve, or the entity charged with policing systemic risk. Some clues as to the Fed’s current thinking on the issue come from recent testimony and the hearings on AIG. The following quotes from Chairman Bernanke mirror numerous general statements that indicate the broad view taken by the Fed and Treasury about the nature of the systemic risk posed by AIG, without specifically making any attempt to define or flesh out the factors that might identify a systemically important institution. The comments don’t talk about the nature of AIG’s business nor the interconnected aspects of its relationships. Rather they focus on the unspecified and amorphous likely costs of its demise:

"In the case of AIG, the Federal Reserve and the Treasury judged that a disorderly failure would have severely threatened global financial stability and the performance of the U.S. economy." (Bernanke testimony before House Committee on Budget, October 15, 2008)

More recently, in a speech, Chairman Bernanke put a bit more flesh on his view of the concept: "In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy." (Bernanke, "Financial Reform to Address Systemic Risk," March 10, 2009) The implication in this statement is that it is not only the size of a firm but also the nature of its business that is important in identifying a systemically important institution. However, Vice Chairman Kohn quickly disabuses us of this view in his testimony before the Senate Committee on Banking, Housing and Urban Affairs, in a verbal response to a question about systemic risk, how the Fed viewed AIG, and why it intervened: "Let me be clear… Our actions were not aimed at AIG or its counterparties. Our actions were aimed at the US financial system and the knock-on effects of imposing losses on counterparties. Would those counterparties be willing to do business with other systemically important US institutions that might someday end up in the government’s hands?" (Kohn verbal testimony, March 5, 2009)

This view states that the Fed acted because of the possible reactions of the counterparties of other unidentified US institutions that might be taken over by the government at some unspecified time in the future. The logical questions for the Senators to have asked are: Who are these institutions? What information was relied upon in making this judgment? What kinds of input was received and from whom on the likely reactions of counterparties? These questions become important because the statement clearly implies that a supervisory authority or systemic risk regulator could not simply look at AIG, its size, or information on its counterparties to judge the effect that its failure might have had on other parties in the market. The Fed apparently made a judgment about the likely reactions of counterparties of other firms and acted on those considerations. This justification and potential costs can’t be evaluated ex ante and can’t be verified ex post. Hence, there is no accountability possible. To give an institution – the Fed or Treasury, for example – carte blanche authority to commit potentially large amounts of taxpayer resources, as was done for AIG, on the basis simply of an assertion about likely costs that can never be explicitly identified nor verified, is a broad grant of power that should not be taken lightly.

Chairman Bernanke, as reflected in his speech on systemic risk before the Council on Foreign Relations, has clearly given a lot of attention and thought to the issue, and also seems to have in mind that the Federal Reserve should play a role, perhaps even as the systemic risk authority. Before that authority is given, the following are a few questions that should be addressed to the Fed, or any other existing entity if not the Fed, that might be given systemic risk responsibilities:

  1. The assertion is that the Fed lacked needed authority to resolve the failures of certain key institutions like Bear Stearns and AIG. With hindsight, if the Fed had FDICIA 1991-type closure remedies available to deal with Bear Stearns or AIG, would it have solved the problems differently? If special closure rules were to be provided, what should be the scope and reach in terms of specific classes of institutions and entities covered? Would it include insurance companies, or conglomerates like GE and the auto companies, which have large financing arms? More specifically, what criteria should be put in place to decide when certain institutions should or should not be included, and how could they be taken off the list?
  2. The implication has been that the lack of specific systemic risk authority hampered addressing the financial crisis. What would the Fed have done differently, had it been officially designated as the systemic risk authority – both in advance of the crisis and during it?

  3. Should the Congress attempt to define systemic risk? Should it leave that decision solely to the systemic risk authority without any guidance, and "trust" that it will do the right thing? Should Congress follow the model established in the Bank Holding Company Act, which delegated to the Fed the authority to define permissible new activities subject to a specific set of findings that had to be reached?
  4. If the Fed had been the systemic risk authority, would that have affected the decision to keep interest rates low for as long as it did, coming out of the 2001 recession?
  5. Should a specific list of documented findings or criteria, such as demonstrated linkages among counterparties, be required of the systemic risk authority if it intervenes to save an institution deemed to be too -important to let fail?
  6. Would the Fed have forced the creation of a derivatives exchange as a means of reducing counterparty risk, and if so, when would it have done so and why?
  7. Should a dollar limit be imposed upon the amount of funds that could be committed by the systemic risk regulator without the approval of the Congress?
  8. The Fed has argued for authority to monitor and regulate exchanges and payment and settlement systems. Why is this necessary, since the systems worked as designed in this crisis?
  9. What sort of ex post review should be required to evaluate the performance and decisions of the systemic risk regulator in the event that a crisis occurs? Should an outside review by a Congressional committee be required, or should it be conducted by the Inspector General?
  10. What transparency requirements should be required of the systemic risk authority?


The AIG case raises numerous important issues, the answers to which are not always clear or obvious. There is a movement afoot to embark upon a series of financial reforms, and the likelihood is that they will include the designation of the Fed or some other body to take on the specific task of being responsible for monitoring and dealing with systemic risk. Without careful thought, granting such authority may entail great costs to the taxpayer in the event that another crisis occurs, and with uncertain benefits. In addition, care must be given in expanding the responsibilities of existing regulatory agencies; for as Chairman Bernanke clearly articulated in some of his writings before ascending to his current position, new authorities and responsibilities can also carry with them conflicts among competing goals and can sometimes distract an agency from its principal objective.

The Times, They Are A’Changing

The lead article in the Friday, March 13th Financial Times reported that Wen Jiabao, the Chinese premier, warned the United States to take measures to guarantee its “good credit,” expressing concern about China’s large holdings of US assets.  The White House felt compelled to reply promptly that Mr. Obama intends to return the country to fiscal prudence once the financial crisis passes. "There’s no safer investment in the world than in the United States," said presidential spokesman Robert Gibbs. The economic reality of today dictates that the US has to pay serious attention to the views of governments of major emerging market economies, particularly those on which we will depend to continue accumulating the growing volume of US public debt. No longer is it only the views of seven advanced industrialized economies (the Group of 7 finance ministers and central bank governors of Canada, France, Germany, Italy, Japan, the UK, and the US) that “count” in international financial and economic deliberations.

This new reality was reflected in the meeting last weekend in London of the finance ministers and central bank governors of the G20 (Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, the United States of America, and the European Union) . The meeting was held to prepare for the meeting of the heads of state of these countries early next month. The G20 countries account for 85% of the world’s economic output.  The country grouping does cover most of the globe’s major players (the exclusion of Taiwan and Singapore and inclusion of Argentina and Turkey could be questioned).

Also last week the Financial Stability Forum (FSF) announced an increase in its membership to include all member countries of the G20. The current membership comprises national financial authorities from the G7 countries, plus Australia, Hong Kong, Netherlands, Singapore, and Switzerland. The additional members from the G20 will be Argentina, Brazil, China, India, Indonesia, Korea, Mexico, Russia, Saudi Arabia, South Africa, and Turkey. In addition, Spain and the European Commission will become members. Thus the number of “countries” will more than double, from 12 to 25.  Noting that each country will have representatives from its finance ministry (or treasury), its central bank, and its other financial regulatory agencies (such as the SEC for the US) and that the major international financial institutions and international regulatory and supervisory groupings will also attend, there will be quite a crowd participating in future meetings of the FSF.  This will be a considerable challenge for those responsible for organizing effective deliberations.

These developments contrast sharply with the thirty years’ experience of this writer in the US Treasury and the Organization for Economic Cooperation and Development (1974-2005). The received wisdom in those institutions was that high-level international financial deliberations should be kept in exclusive groups that include only the key advanced economies, preferably the G7 countries, if not even smaller groupings.

Most, but not all, of the reasons for this restrictive stance are no longer valid. The Cold War is over (which accounted for some of the political considerations).  The key creditor nations with substantial foreign reserves now include countries like China, Saudi Arabia, and Korea. And the relative economic importance of the emerging market countries is now much greater. The IMF calculated that these countries accounted for some two-thirds of the growth in the global economy in 2007.  While final numbers for 2008 are not yet available, a similarly significant role is likely to be shown for last year.  The importance of emerging markets in the global market for equities has also increased. The capitalization of emerging markets’ stock markets has increased by a factor of four over the last 10 years, from 6.3% of the global stock market capitalization in 1998 to 23.2% in October of last year (even after a substantial market drop).

One reason for more limited groups which still has some validity is the practical consideration that the larger the group, the more difficult it is to have frank and efficient discussions, particularly when all participants wish to engage in the debate. If twenty countries wish to express views on a topic, the time required is substantial. Add time for some give –and –take, and the number of issues that can be covered in a meeting is very limited.  Also, the challenge of reaching a consensus on any action is likely to be greater.  For these reasons, the G7 meetings of finance ministers and central bank governors are likely to continue to be held – at least until the G20 meetings prove to be effective.

It appears that this weekend’s G20 meeting was successful in the eyes of the participants. Governments are on course to deliver a global fiscal and financial stimulus of unprecedented proportions and major financial sector reforms. US Treasury Secretary Tim Geithner applauded the strength of the G20’s “consensus on the need for both recovery and reform, so that we will never face a crisis like this again.”  Agreement was reached on an agenda for the heads-of-government meeting and for moving forward on a deal to increase substantially the funds available to the IMF to deal with financial crises and to give emerging market economies a greater voice in international financial institutions. There was also agreement on broad principles to guide the reform of the financial system, including stronger oversight of important financial institutions, increased disclosure for the derivatives markets, and registration and regulation of credit-rating institutions.

Also notable was a call by the G20 finance ministers for increased information sharing to counter tax evasion. This coincided with a remarkable number of announcements last week of concessions on tax secrecy by some of the world’s leading private wealth centers, including Switzerland, Austria, Luxembourg, Hong Kong, Singapore, Liechtenstein, and Andorra. After resisting for a number of years, they have bowed to pressure to adopt OECD’s international standards on transparency – and in time to avoid criticism by the G20.

Along with their increased role in international financial discussions, emerging markets are fulfilling expectations that they will outperform advanced economies in the global equity market in 2009. Taking account of last week’s advances, the MSCI Emerging Market Equity Index is down only -4.8 % year-to-date. This is only one third as large as the decline in the MSCI Equity Index for the US market, -16%, and one fourth of

the  – 21.2% decline in the MSCI EMU (Eurozone) Equity Index . The MSCI China Index has moved very similarly to the overall Emerging Market Index, -3.1 % year-to-date. Several emerging markets as measured by their corresponding MSCI indices are actually up this year, including Brazil + 8%, Chile +12.1% and Taiwan +2.4%. Cumberland’s International, Emerging Market, and Global Multi-Asset Class portfolios have over-weight positions in these markets.

Three Quick Points About the Fed

First:   As the Federal Reserve starts its two day meeting today, Chris Whalen just released his notes regarding an unpublished Fed research work.  The summary is below.   The link to his letter is: .

“The following article on fair value accounting ("FVA") was authored in May 2007 by a researcher who at the time worked for the Federal Reserve System. The paper, which was not approved for publication by the Fed Board’s bank supervisory staff, outlines some of the issues in a transition to FVA, issues that have turned out to be critical. Many of these issues now may be obvious to students of financial institutions and the general public thanks to the financial crisis, yet two years ago the paper was dismissed by the Fed’s staff in Washington. To us, the story around this article provides yet another example of how the intellectual closed-mindedness of the Fed’s Washington staff results in bad public policy.

Some background for context. The Fed and other bank regulators historically did not push back on supervised firm accounting "choices" or otherwise second guess the external auditor on valuation issues for financial firms. That is, if a financial firm could get its paid accountant to sign off on a choice of valuation methodology — choices which in many cases are based purely on "stated intent" at the time to hold an asset for sale or to maturity, then the paid regulator at the OCC (figure roughly 50 examiners for each too-big-to fail bank) and its more poorly staffed step-brother, the Fed (roughly 7 examiners per TBTF bank), would simply accept the decision without question or review.”   

Source: Christopher Whalen, Institutional Risk Analytics, March 17, 2009

Second:  we want to correct an error in our piece entitled “systemic risk”.   We noted that the Fed’s Term Auction Facility (TAF) started slowly and was expanded as the crisis unfolded.   That is correct.   We erroneously wrote that the TAF did not pre-exist the failure of Lehman Brothers.   That was wrong.   The TAF actually started in December, 2007.   It then ceased temporarily and then was resumed by the Fed and expanded as the Bear Stearns affair unfolded in Spring of 2008.   Ultimately the TAF was expanded worldwide with coordinated activity involving several foreign central banks.   Tracking of the TAF and other Fed tools may be found on our website  We thank those readers who caught the typo in our text.

Third:  attention will be focused on this Fed meeting as the Fed discusses the possible implementation of a policy where it will buy longer dated treasury notes and bonds.   This is a very complex issue.   If markets know that the Fed is creating a floor price (ceiling yield) there may be a wave of selling by large foreign holders who were fearful of trying to unload treasury bonds into a thin market.   If the Fed mentions this as a possibility but does not offer a clear policy, it will add an uncertainty premium to market pricing.  That premium will cause rates to be higher than they would otherwise be.   If the Fed is silent, it will send a message that policy options are still under debate.  That will cause a different type of uncertainty premium to be factored into market prices.

The Fed has placed itself into a difficult position by discussing this issue without some firm and resolved structure.   It is now between a rock and a hard place or, as one Fed Governor described it, “it is more like standing between the dog and the tree.” 

Announcements from this Fed two-day meeting will be instructive and require close attention to verbiage; there will be no change in interest rate policy.

Systemic Risk

“Systemic risk is the risk imposed by inter-linkages and interdependencies in a system or market, which could potentially bankrupt or bring down the entire system or market if one player is eliminated, or a cluster of failures occurs at once.

Systemic financial risk occurs when contingency plans that are developed individually to address selected risks are collectively incompatible. It is the quintessential “knee bone is connected to the thigh bone…” where every element that once appeared independent is connected with every other element.”

Source: AIG draft document dated Feb. 26, 2009, ABC News and Barry

Ritholtz website,

We are almost two years into this developing financial mess. Yes, it has been two years since Fed Chairman Bernanke stopped using the word contained in his public remarks when he described the state of things in the money world.

Much of the current activity focuses on the structure of the massive and unprecedented federal bailout of the financial firms and financial system. The bailout is a response to the elevated and intensified level of systemic risk now widely accepted as prevalent and sufficient to justify these unprecedented federal financial actions. The label “systemic risk” is the latest in prominent titling of the state of affairs. Fed Chairman Bernanke’s recent speech elevated the term to “best seller” status.

There are many definitions of systemic risk. In fact it is one of the least precise terms in the current lexicon. It seems to be defined like pornography: “you know it when you see it.” AIG’s self-serving definition is sufficient for this commentary.

Readers may recall our frequent statements about how the failure of Lehman Brothers is the seminal event of our generation. Unpredictably, one of the Federal Reserve’s primary dealers and “AA” corporate credit bankrupted six months after the Fed’s new tools were implemented following the Bear Stearns affair in March of last year. Those Fed tools were specifically designed to support the primary dealers and avoid a repetition of Bear Stearns. Instead, they failed miserably. The “unexpected and unthinkable” happened and the world’s financial environment morphed from an idiosyncratic risk model to a systemic risk model.

History shows that it takes some kind of shock to trigger a systemic risk event. The shock must be bigger and more profound than anticipated. If it is already anticipated both as to size and to type of event, it does not qualify as a shock.

Note that lip-service identification of a systemic risk is not anticipation and preparation. We have heard discussion of bird flu systemic risk for over a decade. Most people on the planet do not act as if they believe it will occur. Thus the precautions are lacking because people are complacent. A pandemic that kills millions of people and overwhelms our health systems will qualify as a systemic risk event. The global financial results would be catastrophic.

Also note that the 9/11 attacks by Al Qaeda had elements of systemic risk in a geopolitical sense, but the risk was contained in a financial sense. The Federal Reserve’s payments system was buried under rubble between the twin towers, yet no meltdown of payments occurred. Payrolls were met throughout the country. Settlements were completed. Defaults did not overwhelm the financial system. The Fed’s contingency plans were placed to avoid risk with Y2K; they mostly worked after 9/11. The Atlanta Fed was the backup for the New York Fed and functioned well. The Fed also massively infused reserves, and its balance sheet expanded rapidly at that time. 9/11 was a tragedy and changed the military and political dynamic of the world. It was not a financial systemic risk event because, unlike in the case of Lehman Brothers, the Fed’s preparations for contingencies worked.

Lehman was arguably the financial shock of our generation. Here are some others that had financial implications. The last generation encountered a shock with the outbreak of the Middle East War in 1973, when the price of oil quadrupled and interest rates subsequently reached the highest levels they had seen since the Civil War. The generation previous to that one received its shock with the Japanese bombing of Pearl Harbor in 1941. And the preceding generation experienced its shock in December, 1930 when the Bank of the United States failed and 500,000 businesses lost their bank deposits. As we can see, financial systemic shocks are mostly but not always the result of the failure of a financial firm.

We know we have a financial systemic risk event when the aftermath is a changed paradigm. Size matters. In systemic terms it simply has to be big.

There were numerous small and rural bank failures in the Depression era. They were idiosyncratic events. But when the New York banking regulators and banking community did not save the Bank of the United States, they morphed that crisis into a global systemic event. Similarly, we are seeing bank failures regularly in the US during this crisis. They are being resolved by the FDIC and do not singly rise to the level of a systemic risk event. Even IndyMac’s failure was an idiosyncratic risk event.

After Pearl Harbor, the United States engaged in global war, levied enormous taxes to fight it, and borrowed huge sums to finance it. Debt exceeded 100% of GDP by the time the war ended. Annual inflation exceeded 10% during the war, while the interest rate on 90-day Treasury bills was maintained at 3/8 of 1% for four years. The twelve regional Federal Reserve banks bought unlimited numbers of T-bills to sustain the rate. The size of the Fed’s balance sheet was virtually ignored.

The argument over whether or not some organizations are “too big to fail” is really a silly one, in my view. There are plenty of folks who disagree with this statement, and I expect the emails will commence shortly. In our view size matters greatly. It is one of the distinguishing characteristics between an idiosyncratic risk event and a systemic risk event.

Remember, after a shock the paradigm shifts from idiosyncratic to systemic. That is what happened when Lehman failed. The damage from Lehman was huge. Global stock markets lost trillions in value in five weeks during the waterfall selloff. Credit spreads widened to levels never contemplated, and many sectors of the financial markets ceased to function. Liquidity disappeared. New issues were halted and the notion of markets as a vehicle to raise capital ceased operation. Bond spreads to Treasuries astronomically widened. Treasuries rallied in price to the point where T-bills were yielding zero interest. A global flight to quality ensued.

Lehman triggered massive and “hurry-up” new monetary tools. They were and are being deployed by the central banks of the world. Our Fed is now proactive and thinking systemically; prior to Lehman it was reactive and thinking only in idiosyncratic terms. An example is the Term Auction Facility (TAF). It didn’t exist before the Lehman failure; it is now huge and has succeeded in reversing the disappearance of liquidity. At first the Fed was tepid with the TAF. They were still trapped by idiosyncratic thinking. Fortunately, they quickly realized their error and enlarged the TAF massively. We saw a similar successful response with the commercial paper facility and with the money market fund liquidity guarantees.

We need to note that it is important to observe how each central bank’s monetary policy is becoming coordinated globally. It has to be that way if policy is to succeed in dampening systemic risk. Governments have become the only credible guarantors of payments. And that is most effective when policy positioning is such that the currency used for payment is that of the guarantor.

Now systemic risk has entered the daily discourse. Once that happens we can expect it to start to subside. Policy pronouncements from the Fed, Treasury, and the Obama Administration are becoming more coordinated and are starting to be believed. Simply put, “there will not be another Lehman.” Other countries like the UK and monetary unions like the ECB are applying their own similar prescriptions.

No one will be able to announce it when systemic risk subsides. Market-based indicators of risk will show it as a trend. The VIX will fall. Credit spreads will narrow. Dysfunctional sectors of the financial markets will resume functionality. The diminution of systemic risk occurs over time and only as events gain clarity and agents accept credibility.

In the United States, there is a compelling necessity to heal and there is massive distrust of the political process. Only in the last week has our new, young, inexperienced president learned that his role must include forward-looking positive statements. Our Treasury Secretary is wounded both from his pre-confirmation revelations and because his attempts to speak clearly have resulted in obfuscation. Sadly for him and for the country, Geithner has become the financial world’s whipping boy.

My colleague Bob Eisenbeis asked, “If a systemic event is an unanticipated shock with broad-based consequences, how does this help us set out what the parameters’ of power should be for a systemic risk regulator?” Bob identifies a key element that is currently under discussion in Washington. Proposals for a systemic risk regulator are circulating now. Congress will soon hold hearings on this and on a new federal insurance regulator that will be designed to replace the 50 states. Part of this initiative is due to the displeasure being voiced at the existing structure used to address the current recipients of financial aid. An example of this displeasure is found in the remarks of Kansas City Fed President Tom Hoenig. He minced no words in his March 6 speech: “If an institution’s management has failed the test of the marketplace, these managers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached.”

Unlike TARP under both Paulson and Geithner, credibility has been maintained at the FDIC. Global agents trust the safety of the insured bank deposit and the pledge of Sheila Bair’s agency to honor its commitments. Runs on banks have stopped.

The Fed could be much more transparent in its public depiction of policy. Communication from the Fed is still arcane and confusing. But the Fed is succeeding in the application of policy even though it is failing at communication. My colleague Bob Eisenbeis will have more to say about this in his forthcoming series on AIG. The Fed’s policy is working and professionals are gaining the ability to rely on it.

We are still in very uncertain and high-risk times. Our current deployment is about 50% stocks, 50% bonds, and zero cash. This is 20 points under the normal 70% stock weight and 20 points above the normal 30% bond weight. We have sold Treasuries. For individuals we emphasize the terrific bargain available in the tax-free municipal bond sector. We advise that bond selection must be done skillfully. The days of relying on bond insurers and credit-rating agencies are over. On the taxable side we emphasize higher-grade corporate credits and taxable municipal bonds.

Readers are welcome to visit our website,, for our comments on global allocations and on various monetary and regulatory forensics or lack of same. We particularly thank former St. Louis Fed President Bill Poole for giving us permission to present his recent speech on bailout programs to our readers. The web link is no longer available.

Bob Eisenbeis’ comments on AIG are forthcoming. John Mousseau, Peter Demirali, and Bill Witherell will be weighing in as well.

We are in Paris next week as Program Chair of the Global Interdependence Center,, with a worldwide discussion of the food and water and global stability issues. Most assuredly, we are eager to moderate the panel on March 26 at the Banque de France with five central bankers, as we discuss monetary policy and how it is applied in this crisis period. The lineup of speakers in Paris is global and first-rate. The GIC partner and host in Paris is the Banque de France; and its Governor, Christian Noyer, has been very supportive of this worldwide dialogue initiative. Delegates will come from around the globe. There are a few seats still available in the GIC delegation. If anyone wishes information, call 215-898-9453 and ask for GIC director, Erin Hartshorn. Cumberland Advisors is a proud sponsor of the GIC.

We are adding a technical endnote to this commentary in the framework of a discussant’s comments. Readers may note that at Cumberland we use an internal vetting process for our Commentaries.

Bob Eisenbeis offered this observation while wearing his macroeconomist hat: “In macroeconomics, the current lexicon talks about shocks which are unanticipated events. But in no way are those shocks regarded as systemic events. They talk about positive shocks, such as an unanticipated upsurge in productivity; and we could talk about negative shocks, such as an abrupt one-time upward shift in energy prices. Again, this would be regarded as a negative shock but not a systemic event. Both the positive and negative shocks would meet your definition of a systemic event. So, I am not sure how to process your view on systemic risk. A key element in your argument seems to be that Lehman’s failure was an idiosyncratic event that became a systemic event because of the Fed’s failure to save it, which then had broad consequences for the entire financial system.”

Bob added, “One idea might be to draw on the parallel concept of “jump risk.” That is, asset risks may be uncorrelated until a shock occurs, and then they suddenly become correlated and have unanticipated consequences and negative spillover effects to all investors in those assets. For example, in normal times a geographically diversified portfolio of mortgages would be risk reducing, because a problem in one local market is independent from events in other local markets. But then an adverse shock occurs to the macro economy, and suddenly housing prices begin to decline across all local markets, meaning that the risks are now highly correlated and destroy the portfolio.”

Kotok response: I think Bob’s point about jump risk has validity. Global markets were relatively uncorrelated preceding the Lehman failure. During the five-week waterfall sell-off following Lehman, nearly all stock markets in the world declined in a highly correlated manner. This action coincided with the spiking of credit spreads and seizure in many market sectors. As the definition of systemic risk evolves, we expect that the application of “jump risk” may be an additional consideration.

Fixing the Banking System

Kotok introductory note:  During the weekend, we participated in a colloquy with Bill Dunkelberg and Chris Whalen.  Our purpose was to examine the banking crisis, the risk in banking liabilities (deposits and debt), and systemic cures.  The full text of the interview follows.

What is the Plan? A Discussion With Bill Dunkelberg and David Kotok March 9, 2009

"I don’t want to nationalize them, I think we need to close them…  Close them down, get them out of business.  If they’re dead, they ought to be buried… We bury the small banks; we’ve got to bury some big ones and send a strong message to the market.  And I believe that people will start investing [again] in banks."   

Senator Richard Shelby (R-AL) "This Week" ABC News

In the wake of the decision last week by the FDIC to raise deposit insurance premiums dramatically and market rumors regarding the possible resolution of a large bank, over the weekend two leading Republican members of Senate called for the government to take strong action to resolve insolvent mega institutions once and for all.  To better understand the perspective of the smaller banks and the bond holders in this equation as the markets seemingly head toward a decision point in New York, we turn to two friends and fishing companions, David Kotok of Cumberland Advisers and Bill Dunkelberg, Chairman of Liberty Bell Bank of Cherry Hill, NJ, and also Chief Economist of the National Federation of Independent Business (NFIB).

The IRA: David, we have spoken a couple of times about the decision by the FDIC to increase insurance premiums and the larger issue of how to fund the bank resolution process now that the numbers are clearly too big for the industry to absorb alone. Most people don’t know that the banking industry stands in front of the taxpayer in terms of absorbing losses to the FDIC due to bank resolutions. But the negative macro wave washing over the global economy is too big and will overwhelm private banking industry capital globally, which is why the markets are panicked. We need a responsible adult to stand up and tell us "what is the plan." Any ideas?

Kotok: There is a big issue here in terms of idiosyncratic risk analysis, which is something we lived with for decades, and systemic risk, which we’ve lived with since the Lehman Brothers failure and also the Washington Mutual failures.  These are cases where bondholders took large losses. Equally or even more importantly, counterparties were in turmoil for weeks or more.

The IRA: We think the US Trustee, the DTCC and ISDA did a great job, but we concede the cost is horrific. You mentioned that you’ve been arguing about the systemic risk issue with people who do not want to see the world through that lens.  Here at IRA, we take the position that systemic risk starts with the particular and is thus, at the aggregate or "systemic" level, a mostly political concept. It’s hard to measure, for one thing, like arguing about "liquidity risk," but lay out your thesis.

Kotok:  Chris we differ. We think that systemic risk is real and requires serious consideration in times like these. Let me try to explain. The idiosyncratic model is the traditional mechanism, the way we and generations of analysts analyzed a structure or a company or a municipality or a sector. We make determinations about risk and reward on a unique and case-by-case basis. The process is that we measure, we estimate, we make determinations in an idiosyncratic way, one element at a time. Lehman was the seminal event of this generation. All the rules changed with the failure of a Federal Reserve primary dealer, the ensuing meltdown in terms of counterparties, the shock to the system as a whole, and the run-up to it. The world morphed into systemic risk: it was no longer about Lehman, the problem became the entire financial system.

The IRA: Yes.  But was not that shock, that surprise due primarily to the inconsistency of policy decisions taken by officials at the Fed and Treasury? They saved Bear’s creditors 100% and gave the equity $10 per share, but then allowed the markets to believe, wrongly, that Lehman too would be saved.  As it turns out, nobody could buy it. 

Kotok: It may be convenient to personalize to them. You and I have done that along with others. But it is a waste of time now. The real focus must be on the sequence with the primary dealers. That is how we can understand the transition from idiosyncratic analysis to systemic risk analytics. Countrywide as a primary dealer was absorbed into Bank of America, another primary dealer. Result: shareholders suffered losses, that’s idiosyncratic risk biting a stock investor but the system was preserved because there was no debt nor counterparty failure by a primary dealer. This was repeated when Bear Stearns was preserved as a primary dealer and merged into JPMorgan Chase (NYSE:JPM).

The IRA: Yes, there was no failure of the counterparty exposures particularly. As we like to constantly remind, the counterparty exposures of the bank subsidiary of a holding company are senior to the debt holders of the parent.

Kotok: Precisely, the counterparty exposures are preserved, the shareholders get wiped out in the case of Countrywide and get a damaging haircut in Bear, but the debt markets and the derivatives markets don’t get shocked; hence, the counterparty structure does not fail and the system continues to function albeit with a rising risk premium creeping into the pricing.

The IRA: But don’t the bond holders and counterparties of the money centers and the GSEs deserve to take a loss? We watch creditors of small banking holding companies getting shot every week, but somehow this ill-defined concept called systemic risk gives the creditors of the biggest, ugliest banks a free pass? Something does not compute here David. The community bankers are going to be seeking the overthrow of the US government by June if something does not give. Do you know, for example, that the State of Washington just assessed a special premium on all banks because a pooled state money market fund took a loss in an FDIC resolution? We cannot continue to stick the cost of this mess to the low risk, small banks and leave the large bank creditors whole, can we?

Kotok: Whether the creditors of the larger banks deserve to fail is a question we can debate for generations, but the reality is that with Countywide to BAC, with Bear to JPM, we did not witness a failure by a primary dealer and we were still in the idiosyncratic mode. Look at IndyMac. It failed as a $32 billion bank that you wrote about last year. Several billion in deposits were not covered, but it was viewed as a bank failure and thus we were still operating in the idiosyncratic mode. But with Lehman Brothers, the unthinkable happened. At least one rating agency still had them at a "AA" corporate rating.

The IRA: The CDS was trading 700 over the curve plus upfront the day before Lehman failed, according to Bloomberg. Yet more evidence of the huge psychological risk pricing head fake the Fed and Treasury’s decision to fail Lehman represented to the market.  Spreads did not even blow out at the end of the day.

Kotok:  Spreads are forward looking and are attempting to adjust rapidly to risk. But idiosyncratic risk is different from an event in which you fail and you trigger systemic risk. Your pre-failure CDS pricing description just proved it.  Lehman triggered systemic risk and we have been living with it ever since.

The IRA: Agreed, but could you not say too that the tangible factor we can identify, that fueled the contagion, was the surprise, not the resolution of Lehman itself?  As we have said before, had Jimmy Cayne been led out of Bear’s HQ in handcuffs several months before, carried live on CNBC, and the Bear equity holders were wiped out in a Fed-managed merger with JPM, the markets would not have been surprised and the dealer would have been conserved.  But we regress.  So what now?

Kotok:  If we apply solutions in a systemic risk concept they must be very broad and consistent. For example, the Fed’s Term Auction Facility (TAF), now that is had grown to a sufficient size, has been successful in shrinking credit spreads. The commercial paper facility has likewise done the job in that sector. The international TAF has started to narrow the LIBOR spreads. When you think in those systemic, macro terms, there are tools and they can help, not all of them, not quickly, but they can help. It is important that they be applied in systemic terms. When the TAF was started it was small and way oversubscribed. The Fed was timid and took the size up slowly. Finally they grasped the need to think in systemic terms. But now we are in a situation where some of the tools we use for resolving banking problems for the largest banks are still idiosyncratic. And these tools do not recognize the systemic nature of this global financial crisis.

The IRA: Fair enough. As we said before, the industry and the FDIC cannot shoulder the load. And we do need a broad plan, a rule, that is consistent and that people can get easily to turn around confidence.  How does it go?

Kotok: That is the way it looks to me.  In that context, here we are with a growing conflict between the big banks and the community banks. We punish one side while bailing out the other. This is another example of idiosyncratic thinking. We bailout of General Motors (NYSE:GM) and GMAC, making them able to compete against Ford (NYSE:F) who is not subsidized. As I said: this is a transfer from the strong to the weak. GM gets subsidy, changes its marketing and undercuts the stronger Ford. The government is creating the next problem instead of trying to avoid it. The government is acting in an idiosyncratic model and damaging the entire system by doing so.

The IRA: I think the short selling pressure on F, GM, General Electric (NYSE:GE) and other names with financial exposure is more of a menace than competition. So long as dealers particularly can write exposure with substandard margins and without having to borrow the underlying stock to run the position, then short pressure is unlimited. The shorts don’t make companies bad, but they drive questionable names into the dirt with overwhelming leverage vs. shares outstanding, short interest or other measures. On exchange short interest in meaningless in the age of credit default swaps. Kotok: Chris, what you described is an asymmetry with the short sellers. They are able to take advantage of systemic risk because many agents, including government, are still thinking in idiosyncratic terms which permits the short to have a one way bet. Level that playing field and you will add risk to short sellers. Reach asymmetry and short sellers will lose their power. The IRA:  Agreed.  When we see everybody playing with uniform margin and collateral, we will get to that place you describe.  Marty Mayer always said that OTC derivatives are about shifting the risk to the dumbest guy in the room. All our channel sources say that Sell Side banks in New York and London stuffed AIG and the Euroland banks to a degree heretofore unthinkable. Again, cash settlement derivative contracts multiply the risk and make these losses possible.  Don’t you agree that the primary dealer failure issue you describe is now even broader?

Kotok: Yes at this point it is no longer about dealer failure but about a more broad based fear of default, of not getting paid as the Corrigan group defined it. That is systemic risk. Sentiment indicators are showing 95% bearish sentiment, as Jim Bianco’s measurement work shows today. We have terrorized an investor class. There is a pile of cash equal to the current value of half the stock market now sitting in money market funds at zero interest. That is an absurdity. It has never been that high.

The IRA: We agree on the problem. Bill what is your view of the market situation and how the FDIC and the Obama Administration seem to be intent upon confiscating the capital of the industry. We hear that the GA governor and congressional delegation went to see Sheila and there’s a line out the door. The new FDIC premium will cost GA banks $400 million in assessments but all the banks in the state earned $200 million in the period used for the assessment calculation.

Dunkelberg: We have a number of asymmetries in the marketplace right now. Bank of America only finances half of its assets with deposits. The other half BAC finances from the markets with debt. There is no tax, no FDIC premium on bank holding company debt, but there is clearly more risk there. So these large banks are out there taking unreasonable risks and they are not even going to contribute their fair share to the resolution on a dollar of assets basis. The huge reduction in the prime rate is another disaster. A third of our balance sheet is tied to prime so we and the other community banks get screwed there too. Then the FDIC comes in and says you got to reserve a lot more money for loan losses even if you don’t have any bad debts. And then they raise the insurance so it goes from seven cents to fourteen cents per hundred of deposits, then sixteen cents. Then they say that they want another twenty cents. For our bank, that is going to be a horrendous number, far larger than we thought would be the case.

The IRA:  It’s even worse than that. Half of C’s deposit’s are foreign, which are not insured or assessed for premiums, so really only one quarter of C’s liability structure is supporting the Deposit Insurance Fund. Is the FDIC confiscating your capital or just income for the period via the new assessments?

Dunkelberg: Well, the dynamics are such that they are confiscating small bank capital. If you are an organic grower as a bank, you add to capital by making money. If you take our income, then our balance sheet does not grow and our share price falls. Raising capital becomes more difficult and expensive as a result. Our returns are lower and the market can see this. So a hike in the FDIC insurance premium has the effect of shrinking bank balance sheets. Just the natural runoff of the portfolio will cause you to shrink if you are not making new loans. It becomes harder to raise private capital, so this situation is a really bad deal for the smaller banks that did the right thing and are now paying the full boat to bail out the money centers. The net effect will be a crippling blow to the small business sector, which is largely ignored in the stimulus package, accounts for 50% of private GDP and private employment, and depends critically on community banks. The small banks are getting hammered and it will trickle down to the Main Street economy that is dominated by small business.

The IRA: David, what principles do you want to see included in a systemic rule? Can we come up with a plan that could possibly move the ball forward so that we could deal with some of the idiosyncratic situations starting with C?

Kotok: Well, the first rule should be for the industrial nations to stand behind bank deposits in their respective banking systems, at least temporarily, and say that they are good. We stop the games with respect to the most senior liabilities in a bank, liabilities that are senior to the debt. Let’s just take this off the table. We basically guarantee anybody who puts a dollar in a bank. You have a situation where you are dealing with systemic risk. You have behaviors engaged in by depositors, for example, to place funds for safety, not for any other purpose, at times for little or no return.

The IRA: So why don’t you call our friends at Promontory Interfinancial Network, who are users of The IRA Bank Monitor?  They will help you place deposits for your clients in good banks and that pay competitive rates of return. And deposits placed by their network are viewed as "core" by regulators, so users can feel satisfied that they are part of the solution and not contributing to bank industry stress.

Kotok: But nobody believes the "A" or "A+" ratings. Chris, this is true even if it is yours. That’s what this is about. The systemic crisis is about all of the idiosyncratic rules being placed into doubt. Bill, do you differ?

Dunkelberg: Savers and investors don’t believe it is safe at the moment. Companies and institutions that we thought were totally safe are now in doubt, so the market is about the return of capital instead of return on capital. We see that at the street level in South Jersey today.

The IRA: OK, so let’s take as a given enhanced backing for deposits. How about the bonds? If the G-10 nations agree on "national treatment" to clean up the mess and the larger nations agree to help their smaller neighbors, what rule do we take in US regarding the bond holders of insolvent banks? If we agree that the equity is wiped in the case of C, for example, and the half of the consolidated balance sheet in deposits is off the table, what about the $600 billion in debt?

Kotok: Well, I have a bias here. I represent bond holders and my clients are bond holders. They have a promise that is different from the promise made to equity holders. We have defaults, of course, but we don’t encourage defaults. I think there is a distinction between the debt side of the balance sheet and the equity side of the balance sheet and as much as possible I don’t want to see the debt side of the balance sheet eroded. That gets us back to systemic risk.

The IRA: The Corrigan group distinguishes between market disruptions and systemic events, with the latter including the quality of surprise a la Lehman, WaMu. Bond holders are represented by agents.  These professionals have watched as regulators encouraged the growth of OTC derivatives and structured assets. These banks publish VaR numbers in their EDGAR filings that disclose above average aggregate risk. Is the bogey man of systemic risk so dreadful that we subsidize the asset allocation choices of professional advisors but put the local bond holder of a community bank to the sword?  Are you are telling me to "Kill Bill" Dunkelberg and other small bankers, to borrow the film title, but not C’s bond holders?

Dunkelberg:  Let me make two points on that before David. First, we should have a progressive tax on deposits or even the entire liability structure of banks based on risk. This way everybody at the party is contributing to the pool and those incorporating more risk to grow will pay more. The idea that only one quarter of C’s liabilities pay into the DIP yet the bank’s maximum probable loss could be a multiple of capital, according to your model at IRA, raises basic issues of fairness. The bigger these banks are the harder they are to manage and understand. The tax ought to be applied to the liability side of the entire institution across the board and then we start to have equity in the industry again. The growth of non-deposit funding for banks and securitizations is the untold story of the current mess.

Kotok: OK, so we now have these FDIC bonds. We have a model for an alternative form of credit enhancement going back to the Muni model in a way. With the onset of systemic risk we don’t have any reliable credit enhancers any more. Even the ones that are not in trouble are not trusted anyway. If we go back to Lombard Street and Walter Bagehot, the modern form should be a penalty rate which is this: we’ll do FDIC insured bonds with a cost attached, which is that a premium to the DIF must be built into the cost of the bonds. This means that this FDIC bond vehicle will be a way for any bank to raise new funds on a term basis and also increase the resources available to fund resolutions by the FDIC.

The IRA: I think we are all coming to the same place here, but we want to bring the discussion back to the bigger issue of funding resolutions, because the industry cannot shoulder the burden IOHO. Even if the money centers had been paying a full tax on their liabilities, which would have far exceeded the funding goals as set during the past few years, the prospective losses would still dwarf the resources available. Specifically, what is the systemic rule for insolvent money centers that need to be resolved quickly but where we need to be creative about how we deal with bond holders?

Kotok: It sounds to me like what we are saying is level the playing field on FDIC enhancement and assess universally. But what is the quid pro quo for bond holders to go along, to play advocate for a minute? What do I take to my constituents? As a practical matter, if we are going to say that the deposits are safe globally, then there must be a cost otherwise you don’t get the safety.

The IRA: But, again, we are asking more basically about C and perhaps several other money centers and even industrials like GE that may face a restructuring. Is there a formula whereby we could offer bond holders a deal to put part of their money down lower into the capital structure as new equity with warrants to provide upside leverage for the risk?  Perhaps Uncle Sam matches the new bond holder equity in C to ensure no loss to the FDIC-backed bonds. We take the other part of the bond holders principal and roll into an FDIC insured security, say 3, 5, and 7 year maturities? If you think of it for C, you increase TCE at the bank level by $300 billion and stabilize the rest of the liability side by locking the bond holders in for a term. We give them certainty regarding 50% of their principal.  With other banks, the haircut to bond holders may be smaller or none at all.  They may just roll their securities into FDIC insured paper and keep on going.

Kotok: Yes, again let’s use the Muni model. Bondholders can take their bonds to the FDIC and pay a premium for the credit enhancement. The FDIC gets the revenue for its fund. The bondholder gets the guarantee and accepts a lower yield. The system starts to clear as uncertainty is replaced with clarity. We already see signs of it when Morgan Stanley (NYSE:MS) gets to issue FDIC bonds and the non-FDIC debt spreads narrow. Why shouldn’t the bondholder pay for the safety? Either the FDIC is a guarantor or it is not. If yes, then its role should be covering liability funding of various types with it s guarantee and, hence, it should get paid by all types of claimants that benefit from that guarantee. It is outrageous that an FDIC bond doesn’t have a premium paid to the DIF at a market based price. Here is a sample of an idiosyncratic solution applied in a systemic risk framework; it amounts to a transfer payment. Get the policy to the broad and macro level; diminish systemic risk. That is how you extend a systemic risk solution and return the system to functionality.

The IRA: Bill, do you think that the equal playing field would be a natural limiter of size in the US banking market? If all banks had to pay a tax on liabilities and their capital requirements were risk weighted, being too big would be a death sentence, don’t you think? Again, to cite Mayer, there are no economies of scale in banking – except in multiplying risk via OTC structures!

Dunkelberg. I was hoping that would be an outcome of the incentives in a leveled playing field. We have confirmed that too big to manage and too big too fail is very expensive. We need to discourage these maniacally big, ego-based banking structures that nobody understands and we can’t run correctly.

The IRA: Well, to extend the concept, would you almost require bank securitizations to pay into the kitty as well? We now know that there is no good sale so maybe we need to evolve the thinking of a level load premium for bank liabilities to include securitizations, which would have to be made more transparent and standardized as the quid pro quo.

Kotok: But you are not going to extend the federal guarantee to the private label securitizations!

The IRA: Well, bank securitizations are about funding. I think if Rosner or Joe Mason were on the line they would at least concede that a bank securitization has to be part of the risk profile of the institution because of lingering control and liability issues. In terms of market share analysis, would not the total footprint of the bank be the real measure? C and the busted SIVs are certainly one bucket of risk, are they not?

Dunkelberg: Well then they must have all of that stuff on the balance sheet. The banks will have to bring the risk back onto the balance sheet and account for it as we have discussed. To the extent that a securitization leaves a tail of risk at the bank, it must be accounted for. Covered bonds or FDIC enhanced, it should all be on balance sheet and just end the issue.

Kotok: Do we need the Congress here? If we need legislation that is a big issue. If we want universal enhancement and a level playing field as our systemic rule, this needs to be done quickly. Are the community bankers strong enough to advance this idea in the Congress? Bill?

Dunkelberg: I don’t know. They are certainly trying. We have already gotten a story from the FDIC that maybe they can cut the twenty cents to just ten if we get a bigger line from the Treasury. I am not sure that Congress has to act on that. We could reduce the tax on the banks in the name of supporting growth and the economy. We need to treat banks as being important and special to the economy – as they are – and not implement policies that are going to further contract credit. The FDIC is attacking its constituents, not helping them get their job done. These policies will hurt Americans more, not help.

The IRA: Correct. There is no point in having the TARP banks recycle government money back to Treasury through higher FDIC premiums, is there? Can we outline some summary points?

Kotok: The key is to address the systemic so we can then address the idiosyncratic risk. That is the key. If we then start to resolve some of these situations, then the markets will react positively. Certainty is what is missing. A plan is what is missing. The Obama Administration is floundering. There seems to be no plan, no design. This is scaring people. The key to any workable plant is to have the systemic elements under control before we try to deal with particular situations. So what points shall we make?

The IRA: How about this as the four action items for President Obama:

1) President Obama, flanked by Fed Chairman Ben Bernanke and FDIC Chairman Sheila Bair, to lead G-10 to announce a temporary sovereign guarantee of all bank deposits, foreign and domestic, and agree to national treatment of bank bond holders and OTC counterparties on a case-by-case basis, using actual realized and probable losses as the decision point for resolution.

2) FDIC suspends all bank insurance premiums for 2009 and directs all depositories to suspend dividends and retain capital to help stabilize the aggregate capital of the industry and thereby the lending base. This would be coupled with access to the Treasury and all the dollars we are pouring into sick institutions in order to finance FDIC activities.  Starting in 2010, FDIC insurance premiums are tied to all bank liabilities, not just deposits, and increase with bank size and complexity.  Need legislation for this.

3) Operating under open bank assistance, the equity holders of C are wiped out. The Fed, FDIC and OCC begin to make board changes and the Treasury invites bond holders of C to form a creditor committee. The new C board recruits new management that knows how to do basic banking. C creditors and FDIC negotiate a 50/50 debt for equity and FDIC insured bond swap. Resolution remains the ultimate threat by FDIC, so the creditors will probably play ball after some yowling. Once C is in hand, Treasury and Fed begin the resolution of AIG and managed "blow up" of the CDS market as now called for by Myron Scholes, among others, and then accelerate active stress assessment of remaining money centers.

4) Treasury then begins to bid selectively for toxic securitizations, contributes these assets to the DIP. FDIC uses its receivership powers to dissolve the DE trusts that are the issuers of the toxic waste, gain control over the underlying loans, and sell this collateral back into the market. As the quid pro quo for the deposit insurance premium relief, the banking industry must be ready to buy these loans from FDIC with financing from the Fed and service/work out same. The community bankers get an asset they can work and shelter from the immediate cost of the large bank cleanup.  We help homeowners without further government subsidy. 

Kotok:  You are heading in the correct direction. In my view a universal guarantee of bank liabilities will stop the bleeding in the system. It must have a clearly defined premium or cost. The shareholders are already wiped out so they have little remaining to lose. The debt markets will pay a price and obtain safety and certainty. The cost or premium can be high but must be transparent. Transparency and clarity are key. Playing fields need to be level and broad to avoid one class subsidizing another. We must get rid of these transfer payments whether community banks subsidizing big banks or Ford having to subsidize GM.

The IRA: Or the US taxpayer subsidizing the counterparties of AIG, as Gretchen Morgenson writes in the NY Times yesterday.  Thanks gentlemen.

Questions? Comments?

Christopher Whalen is the co-founder of Institutional Risk Analytics, the Los Angeles based publisher of bank risk ratings and provider of risk management tools and consulting services for auditors, regulators and financial professionals.  He edits The Institutional Risk Analyst, a news report and commentary on developments in and around the global financial markets.

We thank Chris Whalen for organizing this colloquy.

Investor Eyes Are on the Dragon Economy

On Wednesday, March 4, global stock markets rallied strongly on the expectation that China’s leaders would announce the next day at the opening of the National People’s Congress a massive additional fiscal stimulus program. Thursday, after the rumored announcement failed to materialize, global markets tumbled. These events illustrate the pivotal positive role the Chinese economy is expected to play in the eventual recovery of the global economy. We have shared these expectations for some time. Recent developments have strengthened our bullish outlook for China.

The Chinese economy has not avoided the downdraft from the global recession. The weakness in China’s export markets, combined with the collapse of domestic bubbles in China’s equity and housing markets, throttled back the world-leading 10-11.6% growth rates of the first half of 2008 to 5% in the third quarter and an estimated 1.3% annual growth in the fourth quarter. The Chinese authorities contributed to this slowdown by tightening credit conditions through mid-2008, a necessary step to let some of the speculative pressures out of the above bubbles.

However, these authorities were quick to reverse course early in the second half, after the domestic markets adjusted sharply downward and the developing rapid deterioration in the global economy became evident.  In November a $585 billion investment plan was announced.  The details remain sketchy, but the sheer size, relative to the size of the economy, is approximately twice as large as the US fiscal stimulus package. An additional large fiscal package is likely to be forthcoming. In China’s command economy this spending can be carried out rapidly.

Monetary policy has also been eased in a number of steps, through interest-rate and reserve-requirement reductions and administrative guidance encouraging banks to increase their lending. Today (March 6) governor Zhou of the central bank, the People’s Bank of China, stated that the bank would adopt “fast and heavy-handed” policies to restore confidence. It is important to note that unlike many banking systems in the West, the Chinese banking system largely avoided the credit crisis and is fundamentally sound.

These actions, together with Chinese premier Wen Jiabao’s bold promise yesterday to deliver 8% growth in 2009, make it evident that the authorities intend to take whatever policy actions appear warranted to avoid a further and extended slowdown.  They are in the fortunate situation of having ample resources to do this. And the political imperative to check the massive increase in unemployed workers must be very strong.

Recent data suggest the Chinese economy may well have begun to improve in the current quarter. Outstanding loans increased at a 21.3% y/y rate in January, and money and credit growth was a rapid 18.8%. The Chinese Purchasing Managers’ surveys have risen each of the past three months, after hitting a bottom last November. The increases were across-the-board in February, most notably in production and new export orders. Industrial production also turned up in February after four consecutive months of decline.  In this period of great uncertainty about the global economy, we would not go so far as to say that Wen’s promise of 8% growth for the year 2009 is in the bag.  But our confidence that our own projection of 7% growth will be attained is increasing.

A recovery of the Chinese economy in 2009 to a pace that will likely again lead the global economy will be distinctly bullish for Chinese stocks as well as for stocks in markets closely related to the Chinese economy, including a number of China’s neighbors in Asia and commodity producers around the globe. Cumberland’s international equity ETF portfolios are positioned to take advantage of these expected developments. There are overweight positions in the equity ETFs for China, for the closely linked Asian markets of Taiwan, Hong Kong, and Singapore, and the major Latin American commodity exporters, Brazil and Chile. The Chinese ETFs track the stocks of Chinese firms listed in Hong Kong and/or the U.S., which means they are able to meet the stricter reporting standards in these markets and avoid some of the volatility of the Mainland China equity markets.  In our Global Multi-Asset Class Portfolio, in addition to these equity market ETFs, we also are able to invest in global commodity market ETFs. The massive resource requirements of the Chinese economy imply a compelling long-term case for the commodities asset class as that economy recovers.

A Forecast of the Economic Outcome from Obama’s plan

Kotok introductory note: There are many forecasts of the outcome of President Obama’s stimulus package. Most of them focus only on the domestic US economy, for understandable political reasons. One economist with global skills in the applied arena has modeled the outcome globally and given us permission to share it with our readers. He is David Blond. His credentials are global and well-established, as readers can see by reviewing his paper. The abstract and link to the full paper may be found below.

Measuring the Impact of the American Recovery and Reinvestment Act on the United States and World Economies

By Dr. David Blond, QuERI-International, Santa Fe, New Mexico

Synopsis:The American Recovery and Reinvestment Act passed in February, 2009 will have a significant impact on the US and world economies. It could save or add upwards of 4.6 million jobs in 2009, with an additional 2 million in 2010 in the United States. It would save 94 million jobs elsewhere in the world as a result of the reverse stimulus from the stronger demand for foreign-made products in the US market. Without stimulus, GDP would decline by 2.8% before recovering in the next year with growth just under 1%. The Recovery Act, if it works as expected, would reverse this trend. While first-half GDP would fall, second-half GDP would show some strength, with growth of around 1.4% by the end of 2009 and 2.9% growth in 2010. The effect on GDP growth outside the United States reverses nearly a 1% decline to a 1% growth in 2009 followed by growth of around 1.4% in 2010. While some benefits will pass to the goods-producing sector, the recovery act will not provide the needed stimulus to manufacturing unless the United States reigns in its appetite for foreign-made inputs and finished products. This study uses the QuERI Global Industry and Trade Model to simulate the effects on key sectors of the American and world economies of the additional spending and tax credits. This paper provides an overview of the recovery act, the approach taken to introducing these external effects into the modeling system, the results for the United States and the remainder of the world economy, and finally provides a policy recommendation as to how best to optimize the benefits for the hard-hit, and essential, American manufacturing sector.

Readers may find the entire paper in the “Special” section on our website.(Link is no longer available)

David Blond’s credentials are listed in his paper. His email address and contact information is below. We thank David for giving us permission to share his important work with our readers. Journalists who wish to interview David are advised to contact him directly. These views are his and may not necessarily be those of Cumberland Advisors.

QuERI-International (Link is no longer available) is a small, independent consulting firm specializing in quantitative analysis of international and domestic data. QuERI models have been used by governments, trade associations, consulting firms, and private business enterprises. QuERI databases and models cover 72 countries; 63 major industry groups for production, employment, and international trade; and 300 market-demand indicators; as well data on final demand for private consumption, business, investment, and government consumption. QuERI is located at 357 E. Alameda Street, Santa Fe, New Mexico; 505-820-0250/301-704-8942. For further information contact:   or

AIG: What It Means?

The news on AIG of additional federal funds and a change in the structure of the preferred stock and its implications have rattled the securities markets.  We are scheduled to discuss this tonight on National Public Radio (NPR), “All Things Considered” and on CNBC in the 8:10 p.m. segment and, subsequently, in the 8:45 p.m. segment.

It appears that the changes in terms of the federal support for AIG were triggered by requirements that the “AAA” rating be maintained on AIG’s counterparty risk-based instruments.  The policy behind this federal support seems clearly focused on avoiding a second Lehman-type failure and, subsequent, market meltdown.  The devastation caused by Lehman’s failure was in the counterparty risk arena.    This is the complex structure in which opposing parties of derivative instruments are dependent upon the credit worthiness of each other.  If the instrument requires a “AAA” credit rating, loss of the credit rating can become an element of default. 

Whether we like it or not, America’s federal policy is now driven by the need to avoid another “Lehman.”  Thus, we see increasing federal monies applied to support AIG.  And, we see this elsewhere as my colleague, Bob Eisenbeis, noted about Citi in his comments today.

We can spend hours debating whether or not this is a good or bad policy.  We can spend more time arguing about whether or not Countrywide should have been permitted to fail rather than to be saved via a merger.  We could examine the decisions about Bear Stearns or Fannie Mae or others.  Those are the exercises that will occupy historians and academics for the next several decades.  But those are not the relevant questions for portfolio managers today.

The decisions made today and tomorrow come down to a very fundamental question.  Will, (1) massive federal intervention like preferreds and equity ownership, (2) huge expansion of the Federal Reserve’s balance sheet, (3) trillions of federal contingent guarantees combine to avoid a deflationary prolonged depression? 

History says the answer is yes.  There are no limits to the amount of federal credit that can be extended in support of this new policy.  The Federal government is now committed to do whatever it takes, in whatever amount is necessary and with whatever tools are needed.  If you believe as I do, that the economy will find some bottoming in 2009 or early 2010, then one has to view the future risk several years from now as inflation, not deflation. 

For today, inflation is not the risk, deflation is the threat and enormous new federal credit is the weapon used to confront it.  That’s what the AIG bailout is all about. 

Citigroup: Who Has the Pea?

Last Thursday the US Treasury agreed to convert $25 billion of TARP Series H Preferred Stock into common equity at an exchange price of $3.25 per share.  The stated goal of this exchange was to increase the bank’s Tangible Common Equity and thus ensure more investor confidence in the institution’s long-term prospects.  This transaction is nothing but an accounting shell game which doesn’t inject new funds into the institution but simply reorders the priority of claimants in the event the institution should fail.  Specifically, it moves both the taxpayer and other preferred shareholders who accepted conversion of their private preferred stock to common equity into a first-lost position.  While giving the taxpayer a larger ownership share, the transaction also increases taxpayer risk exposure and removes the promised dividend payment that the preferred stock carried. 

Recently, policy makers appear for some unexplained reason to have become obsessed with Tangible Common Equity (TCE) as the appropriate measure of a firm’s capital adequacy, when traditionally banking supervisors have focused on Tier I and Tier II capital.  The FDIC, for example, defines Tier I capital as including not only common equity (TCE), but also noncumulative perpetual preferred stock, surplus, and retained earnings.  Minor adjustments may be made to recognize losses and certain other disallowed items.  Tier II capital includes qualified subordinated debt and redeemable preferred stock, cumulative perpetual preferred stock, allowances for loan and lease losses, and unrealized gains on certain Available-For-Sale Equity Securities.  Tier I and Tier II components are the main building blocks in the supervisors’ approaches to assessing capital adequacy. 

Conceptually, these capital components are to provide a buffer to absorb losses should adverse risks materialize.  Loss protection to creditors is provided by deposit insurance (now at $250K per insured account) for insured depositors, but more recently the US government has extended guarantees to certain debt issues, as well as against losses on assets.  For example, the FDIC last fall was granted authority to temporarily guarantee all newly issued senior unsecured debt issued by Eligible Entities on or before June 30, 2009, for three years beyond that date.  This includes promissory notes, commercial paper, interbank funding, and any unsecured portion of secured debt.  Also covered were funds in non-interest-bearing transaction deposit accounts held in FDIC-insured banks until December 31, 2009.  In Citigroup’s case, the government has gone even further in its effort to protect that company.  The Treasury, FDIC, and Fed together have arranged to guarantee about $301 billion of its assets against loss. 

All these arrangements significantly complicate the sorting out of who is covered and what assets are actually available (that haven’t otherwise been pledged as collateral) to protect general creditors.  In the end, there are really only two types of bank creditors: those that hold insured or otherwise guaranteed liabilities and those that don’t.  The chief difference among the “don’ts” is where they stand in line when losses are parceled out.  What the Treasury has done is simply changed some other preferred stockholders’ and the taxpayers’ place in line, while providing a small subsidy in terms of forgiving interest of about $ 1.5 billion in yearly savings in preferred stock dividends, which is about 4% of Citi’s current interest expense.  But nothing was done to identify or sort out embedded losses in Citigroup’s portfolio, nor was the cushion increased to absorb those losses. Looking ahead at what this transactions means, clearly there is more uncertainty for banks, especially for the top 19 who are about to go through their stress tests. We don’t know what the stress tests will reveal or how they will be handled. But Chairman Bernanke said in his testimony last week that the intent is not to conduct a pass/fail test.  So what will the regulators do if the need for more capital is determined?  If an investor thinks that a bank might be forced to take a government equity capital injection, for example, then there would be certain dilution and reductions in the value of any outstanding preferred stock.  Given this, it is not clear how or why investor confidence should be improved.