Thursday, June 12, 2008

The Vigorish of OTC: Interview with Martin Mayer

(Institutional Risk Analyst) According to his bio, Martin Mayer, unemployed since 1954, is the author of 34 books, of which four Madison Avenue, USA; The Schools; The Lawyers and The Bankers, were major best-sellers. The Lawyers for many years held the record as the book most frequently stolen from the Mid-Manhattan Library, a reflection, said a librarian, on the kind of kid who goes to law school these days.

From 1952 to 1975 Mayer wrote a monthly column on serious music for Esquire; from 1986 to 1989 he wrote a monthly column for American Banker about banking; and from 1990 to 1992 he wrote a monthly column for American Film about television. In the 1960s he chaired a New York City local school board and served on the Presidents Panel on Educational Research and Development for Presidents Kennedy and Johnson.

Since 1993 Mayer has been a Guest Scholar in economic studies at The Brookings Institution. The IRA spoke to him during two interviews in New York last week, including lunch at Spark's with IRA CEO Dennis Santiago.

The IRA: Martin, how do you reckon the cost of the subprime debacle so far? Where are we in the adjustment process and where are we going?

Mayer: Gillian Tett has a piece in the Financial Times today saying that banks are unable to resist demands that they tighten up on capital standards, demands which they have been resisting. There was a Basel report after the failure of Long Term Capital Management prepared by a bunch of younger people associated with the Bank for International Settlements. A lady named Susan Krause, who was Deputy Comptroller for International in those days, was the US representative to this effort. And they came up with some very sensible proposals which, if they had been adopted, would have helped avoid much of this mess, but of course Alan Greenspan killed the proposals.

The IRA: Did you see the article by Larry Summers in the Financial Times? Offering us prescriptions to solve the crisis which he helped to create? The New York Times ran a great article on April 27, 2008 ("Where Was the Wise Man?") describing how Greenspan, Summers and Bob Rubin worked to stifle regulation of the OTC markets.

Mayer: I am not a big fan of that proposal, but it is not that easy to design something that will keep the banks from cheating on capital requirements. The SIV is a particularly blunt instrument. The odd part of the current crisis is that we've just been through Enron and the banks paid out a lot of money because of what they did with Enron. Leave 'em alone and what do you get? More SIVs.

The IRA: Bob Feinberg described that process beautifully in our interview earlier this year. After Enron, the SEC and the FASB simply tweaked the criteria for determining control for SIVs and Wall Street kept right on going. Enron was a broker-dealer after all. The off balance sheet vehicle model was under development in the private banking world for many years before Enron.

Mayer: Well, the SEC under George Bush and Chris Cox has been a disaster. I testified before the House Banking Committee when Cox was a congressman. It was in the days of Charles Keating and American Financial Corporation.

The IRA: Ah yes. I wonder how many people remember that John McCain (R-AZ) was one of the Keating Five? Keating paid millions to Senators Dennis DeConcini (D-AZ), Alan Cranston (D_CA), John Glenn (D-OH), Don Riegle (D-MI) and McCain. And Keating spent four years in prison. The McCain-Keating connection sort of evens the balance with Barack Obama and Tony Rezko, who was just convicted of corruption charges in a Chicago federal court.

Mayer: Well, one of the things I pointed out about Keating was that American Financial was not his first scam. He had sold lobby notes. He'd done that earlier with a bank in Cincinnati. This was an invitation to fraud and it was something that he had a record of doing. And Cox said that he could not see what was wrong with it. And I thought to myself; this guy is a congressman. He represents Orange County, a community that was really victimized by Keating. Lincoln was the largest lender in Orange County and as soon as Keating took it over he moved the whole lending operation to AZ. He kept the deposits in CA but he moved the lending to AZ. You'd think that a congressman like Cox or even Senator Alan Cranston would be annoyed with Keating for taking assets out of the state, but no, no, he was never criticized.

The IRA: We had great hopes for Cox. His tenure has seen a series of disasters at SEC, not all of his making, to be fair. The handling of issues such as the rating agencies, market structure, fair value accounting and securitization all fall to some degree at his doorstep, but he has been unwilling to take on the constituencies affected.

Mayer: Chuck Schumer (D-NY) was a congressman at the time and we were taking about the Keating Five and who did what to whom. And I said that of the Keating Five, Cranston was the worst offender. First, he was calling people up at five in the morning to get members of the Home Loan Bank Board to vote Keating's way and authorize expanded investment powers for S&Ls. Second, he was claiming Keating as a constituent even though the man took all of the productive activity out of the state! And Schumer said to me, this is almost two decades ago, that it costs a million dollars per month to run for Senate in CA. Keating gave Cranston a couple of months off and Cranston was grateful.

The IRA: So how do you compare a crisis like Keating with today?

Mayer: This one is different because it is to a large extent structurally based. Particularly, it is the lunacy of letting Wall Street set up this over-the-counter market with some $60 trillion in alleged liabilities. That did not have to happen. Wall Street could have gone to someone like Jill Considine at The Depository Trust & Clearing Corporation, which was set up to handle precisely this type of market need but was never given the chance. At least now they have a warehouse set up for swaps. Before the DTCC warehouse there was nothing. You had Jerry Corrigan crying in the wilderness as he always does, warning that we don't really settle these swaps

The IRA: Yes, he and his colleagues in the Counterparty Risk Management Group have addressed some of the issues piecemeal. We questioned him on these same issues back in 2006 in preparation for an editorial in Barron's ("The Derivatives Problem: A New Form of Risk"). We asked Corrigan whether these OTC swaps and the like did not need to be traded on an exchange. And he took the Sell Side position one would expect from an official of Goldman Sachs (NYSE:GS) and that that, no, that users needed customization that could not be provided in an exchange traded contract.

Mayer: The banks want the customization. They get an extra vigorish from customization.

The IRA: What percentage of the users of OTC swaps really need customization? Despite his lifetime of selfless public service, Corrigan seems to us to be talking the Sell Side's interests now.

Mayer: I am a big fan of Jerry but he is not a fan of mine. I don't know what he is going to come up with now. He is working on another CRMG report. He did raise the right questions over the years.

The IRA: Agreed.

Mayer: I got to know him a little by writing a profile for, can you believe, the Fordham alumni magazine. He couldn't really say no. Corrigan is not that easy of a guy to ask difficult questions. I spend some time with him and wound up with a positive feeling. First off, I am prejudiced for people whom Paul Volcker likes. Paul is the last honest man in the world. He was the source of Corrigan's authority and clearly trusted him. That counts for a lot.

The IRA: What is it about financial guys and fishing? We're going off to ME in a couple of months with David Kotok of Cumberland Advisers for the Shadow Jackson Hole fishing trip, economic prognostication contest and poker tournament. Maybe we'll add speculating with respect to LIBOR to the mix this year.

Mayer: What is happening on this LIBOR business? That is a very strange story that the five big banks are cooking their books on reporting LIBOR.

The IRA: Well, with many banks now struggling to fund themselves, the larger banks don't want to be seen as aggressively bidding in the funds markets for fear of starting a reputational issue a la Bear, Stearns (NYSE:BSC) or Lehman Brothers (NYSE:LEH). LIBOR is a manifestation that global investors don't want to lend to US or even EU banks.

Mayer: That is a very serious statement.

The IRA: Meanwhile, our friend John Dizard reports in the FT that the bond markets are once again back in negative basis territory, meaning that you can buy the bond of a corporate and purchase credit default swaps or CDS insurance for less than the yield on the bond. In theory, a risk free trade, assuming that party providing the protection pays.

Mayer: But the question is: What is that protection really worth? You have a claim on a counterparty. And there is a vast system of counterparties in this OTC market behind which, in theory, the Federal Reserve now stands. It's not a stable situation. People are still hiding losses. The notion that the Fed is taking junk paper from dealers and swapping Treasury debt so that these guys have something to repo is outlandish. This is one reason why I am not sure whether Ben Bernanke knows what he is doing.

The IRA: You and Paul Volcker. The terms of the Fed's role in the Bear, Stearns rescue are outrageous. Having Ben Bernanke and NY Fed President Tim Geithner negotiating with the bankers from JPMorgan Chase (NYSE:JPM) was ridiculous. The taxpayer deserves adequate representation in such a situation. We keep hoping that the FRBNY board of directors will appoint as president an experienced internal candidate such as Bill Rutledge or Terry Checki, but the FRBNY presidency seems to be a purely patronage post. Even an outsider with real world financial experience, such as former DTCC CEO Jill Considine, would be a great choice to head the FRBNY. In fairness to Bernanke and Geithner, neither have any real experience working in the financial markets.

Mayer: I am not willing to be critical of Geithner. There are aspects of the Bear deal that I don't think that he realized were there in the pressure cooker of the decision process, but he is a breath of fresh air. Considine, of course, would have had the benefit of a more complete understanding. Before her retirement, Jill was the most powerful woman in American finance. Going back over the past twenty years, there was not even anybody close, but of course the media never noticed. She ran the New York Clearinghouse, then she went to the DTCC when it was just getting started. She added the Securities Clearinghouse to it and then ran it for a decade, making DTCC far more efficient. The whole world is owned by DTCC. Everything. They have immobilized virtually all of the world's securities in their vaults as they should. There were some very serious problems prior to the 1999 merger of The Depository Trust Company (DTC) and National Securities Clearing Corporation (NSCC), problems that we should have settled once and for all.

The IRA: Agreed. But despite the obvious logic of institutions like DTCC, we've still allowed our OTC markets to fragments and thereby become a source of systemic instability. How did this happen?

Mayer: One of the problems I have with the OTC markets and the arguments that we mustn't cramp innovation is that a lot of what is called innovative is simply a way to find new technology to do what has been forbidden with the old technology.

The IRA: Yes, techno-regulatory arbitrage. What a lovely thought; using new technology as a means for committing financial fraud. It's kind of like the affordable housing and innovative financing games.

Mayer: Yes. Innovation allows you to go back to some scam that was prohibited under the old regime. How can you oppose innovation? The fact that the whole purpose of the innovation is to get around the existing regulation never seems to occur to regulators or members of congress.

The IRA: Former CFTC chairwoman Brooksley Born did not seem to have any trouble discerning the difference between innovation and scams. Where is Ms Born now?

Mayer: I don't know, but she has certainly earned the right to comment on the current state of affairs. Ms. Born has made a deposit and she is entitled to do some withdrawing. I still have the concept paper published by the CFTC at the time on the OTC issue.

The IRA: Going back to your point about market structure, how do you explain to people outside the world of finance how we go it so badly wrong? You have a very wide circle of friends outside the markets. What do you tell them? How did Americans forget the lessons of the 1920s and 1930s to arrive at this sad circumstance?

Mayer: In part, it is theory, namely the strange conjunction of Susan Phillips, Wendy Graham and Alan Greenspan over a decade ago. Bill Seidman too, for that matter, when he was at FDIC. In an odd way, we became technologically backward regarding market structure because the people in charge of supervising financial institutions namely the Fed -- did not know anything about it. Look at the Fed's employment roster. There were people who were obsessed by monetary theory. And there were people whose chief responsibility was performing tasks like handling checks, namely operations. There were various models of equilibrium in circulation at the time which provided overall comfort. And Alan Greenspan really believed with religious fervor that markets cure their own ills. Remember Barry Bosworth's warning that diversification devalues knowledge. So the notion that the technology made it possible to drive risk beyond any reasonable limit wasn't in anybody's head. As I said before, there are a certain number of tested Wall Street scams that have been forbidden by regulation. If you can find a way to use technology to revive one of these scams, then you are an innovator and you get paid extremely well for the five years these techniques work, and then you go away.

The IRA: How can other nations around the world take the US seriously when we show such a capacity for collective self-delusion?

Mayer: Yup. In addition to using technical innovation to evade regulatory limits, there was also a confusion of purpose at the Fed. The Fed really never wanted to exam banks. And it really didn't want to be in a admonitory position vis-a-vis the banks. The commercial banks are the mechanism by which monetary policy is conveyed to the world. And the Fed needed them very badly. But beyond just monetary policy, what got forgotten was the reason why we separated commercial banking and investment banking in the 1930s. Obviously it got more and more difficult to enforce that separation as the technology changed. But that didn't mean that there were not good reasons for the continued separation. The way I like to put it is that the commercial banker wants to know how am I going to be repaid, the investment banker asks how am I going to sell the paper. These two attitudes really do not coexist well together.

The IRA: Banks globally have been miserable failures when it comes to combining investment and commercial banking.

Mayer: Correct. It is a very different mindset. And historically, in terms of public policy, we have relied upon the commercial banks to keep the markets and the economy on an even keel. Greenspan's observation was that, after all, the banks are going to protect us because they are lending their own money

The IRA: Yes, but in a market dominated by investment bankers, no such discipline prevails. The investment bankers rarely create value and, judging by their recent behavior, care nothing about the long-term health of the global markets or the economy.

Mayer: Well, of course that was inaccurate because commercial bankers lend other peoples money. But beyond that, the notion that people who gamble with their own money are more responsible gamblers than those who gamble with their Uncle Joe's money was always very strange to me. People who are gamblers are gamblers and they will run through anybody's money. The difference between their own money and other people's money usually does not mean much to a gambler.

The IRA: In the last issue of The IRA ("Talking About RAROC: Is 'Financial Innovation' Good for Bank Profitability?"), we talked about how the risk-adjusted returns in the banking industry fell sharply after the deregulation of the 1990s and the growth in competition for the basic services provided by banks. Wasn't it inevitable that banks would go further and further up the risk curve when we deregulated their basic business? Today we hear regulators calling for more capital in banks, but that implies that risk-adjusted returns will be negligible.

Mayer: The name of the game was always to minimize the allocation of capital. When I was young, the number was 10% capital to assets. And then the BIS brought us down to 4% bank capital. And then we have the great comment by Citicorp CEO Walter Wriston that Citi needed no capital because it was inconceivable that the markets would not lend.

The IRA: Sounds like what people say today about the GSEs.

Mayer: That's right. Our current situation is a very interesting one. I've been getting some interesting emails from Walker Todd and Ed Kane on this subject.

The IRA: Kane's article in the Journal of Financial Services Research, "Basel II: A Contracting Perspective," would be funny if it were not so sad. He writes that "Financial safety nets are incomplete social contracts that assign responsibility to various economic sectors for preventing, detecting and paying for potentially crippling losses at financial institutions." And this in an election year!

Mayer: Kane is a very amusing guy and very sound. His coinage of the term "zombie thrifts" was one of the great features of the 1990s. But to go back to the thought, where all of this business with the Fed supporting Wall Street starts really with Continental Illinois. What happened was that in order to keep Continental Illinois going, the FDIC had to buy the billion dollars of notes the holding company had sold in Aruba. The FDIC was not willing to put up the money, so the Federal Reserve Bank of Chicago loaned money to the FDIC to carry Continental Illinois until they could sell it off. The Board of Governors of the Fed, remember, has no money. Silas Keehn threatened to call the loan. There was a congressional hearing which I quoted in my book The Fed where Seidman said in a jocular way that if the Fed wanted its money back they could close down the FDIC because he could not pay them! So you developed a situation where the lender of last resort to the banking holding companies was the FDIC. And the lender of last resort to the FDIC was the Federal Reserve. The Fed began to get into very non-standard situations after that, as in the case of the Bank of New England failure where the FDIC was again using the Feds money.

The IRA: Well, again, they did not have the liquidity. But the odd thing about both of these situations was that the FDIC did not first go to the Treasury via the Federal Financing Bank. By statute the FDIC has a credit line directly with Treasury, yet instead they went to the Fed.

Mayer: Correct. The FDIC had the reserves in both cases, but they did not want to use them. The FDIC insurance would not be as meaningful if the agency itself were seen to be in difficult financial straits.

The IRA: So these types of innovative financing techniques by and between the regulators are essentially the precursors of what we see today, albeit with the Fed now lending directly to the insolvent non-depository institutions like BSC and perhaps LEH.

Mayer: Yes, that is where I see this situation we have today with the Fed holding billions of dollars in junk paper starting, with Continental Illinois and the like. You see, one the problems that the FDIC had in Continental Illinois was that the bank had a billion dollars in offshore deposits. The FDIC had no legal authority to bail out these depositors. Another example was the National Bank of Washington

The IRA: Oh, NBW. One of our favorite bank resolution train wrecks. A bad bank that should have been closed and liquidated, but was instead sold to Riggs National by the OCC. The NBW transaction was arguably the beginning of the end for Riggs.

Mayer: NBW had $400 million in uninsured offshore commercial paper. Among the people who held that paper was Brent Scowcroft. There were all of these ways that people could do things that were ultra veris and the Fed backed it up. The Fed's problem this time around is that they are trying to do things overtly, to get banks to use the Discount Window openly, for example, but when LEH did so the market jumped on them. It was a clever idea for the Fed to have the auction facility, but since people are increasingly concerned about the financial condition of counterparties, it is hard to use the Fed facility openly. And going back to an earlier point, this preposterous OTC market in things such as credit derivatives, all of those swaps, make you much more dependent upon the quality of your counterparty.

The IRA: The credit quality of counterparties is never explicitly priced into an OTC swap and, in theory, is instead addressed within the bilateral relationship with the dealer! We have shifted the risk from the aggregate level via exchanges to individual firms, thus the failure of BSC and the near-miss for LEH, which apparently is still ongoing.

Mayer: Of course. Everybody says that the trillions of dollars in notional exposure in OTC markets like CDS are not important, but within these notional amounts are counterparty relationships that have weak links.

The IRA: Yes, when an OTC trade fails the notional amount becomes very important.

Mayer: That's right. Suddenly for somebody that notional amount becomes real.

The IRA: This is one reason why we have been so vocal about the situation with Bank of America (NYSE:BAC) acquisition of Countrywide Financial (NYSE:CFC). If BAC goes ahead with the transaction, then the cost of dealing with CFCs total liabilities, including litigation, may force a bankruptcy of the non-bank operations of CFC. BAC has said as much repeatedly. Obviously the Fed wants the deal to close because the alternative to a purchase, namely the takeover of CFC's bank unit by the FDIC opens many cans of worms, including the prospect of the FDIC abrogating swap contracts which flow through the bank. Acting as receiver, the FDIC has unilateral power to revise or reject contracts by a failed bank. The party expecting to receive in a swap contract might find themselves as general creditors of a bank resolution.

Mayer: They have put the derivatives contracts ahead of the other creditors, by law.

The IRA: Yes, the parties to a netting agreement are exempt from the automatic stay in bankruptcy. But going back to your point about the notional amount being important, the happy squirrels at ISDA thought that they could protect OTC derivatives trades by getting an exemption to the automatic stay. But that outcome assumes that there is sufficient money available to make the payment. If the moneys are insufficient, then the receiving party will end up filing a claim in bankruptcy -- unless the Fed bails everyone out.

Mayer: I keep wondering how banks like Citigroup (NYSE:C) and others managed to get all of that money out of the Persian Gulf states. Maybe that Saudi prince who rescued Citi before made money at it. But they are not going to make money this time. We have not been very good at allocating losses. We do them on the sly and then try to inflate them away. But I don't think that we can do that now.

The IRA: Well, there does not seem to be any inflation possible on the wage front. US consumers are only losing purchasing power due to global free trade. In terms of wages, the US faces continued deflation, so this can't help the overall credit standing of the US economy. But going back to the OTC issue, how do we fix the illiquidity in the financial markets?

Mayer: In the second edition of The Bankers, about two thirds of the way through, I promulgated three laws of financial derivatives. The first law is that when the whole is priced to sell for less than the sum of the parts, some of the parts are overpriced. Second law is that when you segment value you segment liquidity.

The IRA: So much for innovation.

Mayer: And the third law is that risk shifting instruments will tend over time to shift risk unto those less able to bear it because them what's got want to keep and hedge, and them that ain't got want to bet and speculate. Three laws from the 1990s and all three still true. This business about appetite for risk or ability to shift risk is all crap. The banks and funds own some of this junk, but not so much. They don't seem to be howling nearly so much as the guy who packaged these assets and stupidly kept inventory.

The IRA. Correct. We can recall years ago bugging BSC CEO Alan Schwartz about our bank risk tools. His response was that we don't take much counterparty risk. Our only risk is our mortgage conduit. That turned out to be a very prophetic statement. The firms that got into packaging have been among those hurt the most by the downturn.

Mayer: Besides the liquidity issue, the dealers developed an appetite for the higher yielding tranches of these deals. But when you think about it, that shows such a lack of understanding of the business!

The IRA: To change the subject, how do you see the Fed's policy in terms of interest rates and the dollar? You mentioned that you were refinancing a floating rate HELOC for fixed. Does that mean that you are a bear on US interest rates?

Mayer: I am a big bear on US interest rates. I like the idea of going to fixed now because, in my view, if you wait until the fall it will cost substantially more.

The IRA: We ran an interview with a former Fed colleague, Dick Alford. He believes that the Fed must get into an increasingly defensive posture with interest rates because of the dollar.

Mayer: To the extent that you've got this crazy linkage between the foreign exchange value of the dollar and oil, which really did get shattered today, then the Fed has a problem. The old fashioned notion that the Treasury or the various finance ministries can talk the dollar up is just not going to happen. The fundamental situation is that we are spending $70 billion per month more than we earn, so how can the dollar strengthen? This is particularly true since we can no longer offer our foreign trading partners agency securities! It was Jim Grant half a dozen years ago who found the footnote in the Fed financial statement about foreign holdings of agency paper. The foreign central banks wanted better yields, so the Fed started buying agency paper and there is now $900 billion of agency paper held by the Fed for foreign official accounts. This paper is held at face value, not at market.

The IRA: We've asked the question too. The Fed, it seems, is exempt from fair value accounting.

Mayer: The real market value of this paper must be down substantially. So the question is this: How do world central banks account for their holdings of agency paper and other such assets, especially OTC derivatives and structured debt, which the Fed holds at face value but is trading at a substantially lower price in the market?

The IRA: Well, the FRBNY is using the last mark from BSC for their book value of the $30 billion in assets taken as collateral. How's that for creative accounting? Wonder if the FRBNY's auditor will have a problem with this treatment?

Mayer: Nobody applies the rules to the Fed.

The IRA: So what projects are you working on now?

Mayer: I actually have something in process which is well-advanced. A collection of illustrations, such as the advice Count Oxenstierna gave his son Gustav Second: That you do not know with what unwisdom the world is governed. It is a collection of similar anecdotes, all true.

The IRA: Sounds like a reference from our friend Timothy Dickinson in Washington. Well look forward to the book and to speaking with you again soon. Thanks Martin.

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