Tuesday, June 30, 2009

Wary Banks Hobble Toxic-Asset Plan

Posted in the Wall Street Journal by David Enrich, Liz Rapaport and Jenny Strasburg:

The government's plan to enable banks to dump troubled assets is facing troubles of its own.

Markets initially rallied when Treasury Secretary Timothy Geithner announced in March a two-pronged plan to offer favorable government financing to entice investors to buy bad loans and toxic securities from banks.

But that initiative -- called the Public-Private Investment Program, or PPIP -- has lost momentum. Big banks worried about having to sell at fire-sale prices while small banks feared they would be shut out. Potential buyers balked at the risk of doing business with the government, concerned that politicians might demonize them for making big profits.

The program's problems threaten to stymie efforts by struggling smaller banks, in particular, to clean up their balance sheets. That in turn could hinder efforts to revive the nation's economy.

A look at why the program has stumbled underscores how difficult it has been to solve one of the economy's biggest problems: Mountains of bad debt sitting on the books of the nation's banks. As those loans and securities lose value, they are saddling the banks with losses and constricting their ability to lend.

U.S. officials and investors are playing down expectations for the plan -- originally billed as a $1 trillion endeavor. Some federal officials say the banking environment has improved since the program was unveiled. They assert that because a dozen or so big banks recently succeeded in raising capital, they are under less pressure to sell bad assets.

Early this month, the Federal Deposit Insurance Corp. essentially shelved one arm of PPIP -- the government-financed buying of bad bank loans. Mr. Geithner recently said the other part -- to facilitate the buying from banks of troubled securities, many backed by real-estate loans -- could be scaled back because investors are "reluctant to participate." This week, the government is expected to name investment firms to manage this securities-buying portion.

"The fits and starts on all this stuff has added to the uncertainty that makes [investors] stay on the sidelines," says Trabo Reed, the deputy banking superintendent in Alabama, where many small and midsize banks are looking for cash infusions from investors.

[Bailout Tracker]

Bailout Tracker

See a breakdown of TARP funds by program.

Lee Sachs, counselor to the Treasury secretary, says the department remains committed to the program and has received more than 100 applications from would-be investment managers. "One of the goals of the PPIP program has been to help create liquidity in frozen markets," he says. "Some banks will sell assets. Even those that do not will benefit from the greater ability to value the assets they hold."

The slimmed-down program will focus not on bad loans, but on toxic securities, which are a problem for a relatively small fraction of the nation's banks. That is bad news for hundreds of smaller banks burdened with growing piles of defaulted loans. These banks are less able to tap capital markets than their larger rivals, so they have been eager for U.S. help unloading loans as a way to bolster their capital cushions. Many of them can face big problems if just one or two large loans go bad. Seventy banks, most of them community institutions, have failed since the start of last year. Analysts are bracing for hundreds of lenders to collapse in the next few years.

Because these lenders often play key roles supporting their local economies, taken together, they are important to the financial system and to a U.S. economic recovery, says Kenneth Segal, senior vice president at Howe Barnes Hoefer & Arnett Inc., an advisory firm for small and midsize lenders.

During the last banking crisis, nearly two decades ago, the government established the Resolution Trust Corp. to sell off the bad loans and securities of banks that had failed. Many experts credit the RTC with helping defuse that crisis.

This time around, efforts to rid banks of soured assets have sputtered repeatedly. In late 2007, federal officials helped cobble together a plan for a bank-financed fund to buy securities held by bank investment funds, but the effort was aborted. In 2008, the Bush administration established a $700 billion program to buy banks' soured assets. Partly because of the complexity of valuing those assets, the U.S. abandoned that plan, instead opting to directly pump taxpayer money into banks.

Scott Romanoff, a Goldman Sachs Group Inc. managing director, has referred to the current effort, PPIP, as "the greatest program that never occurred," because it "created confidence in the markets so banks can raise equity capital."

[Wary Banks Hobble Toxic-Asset Plan ]

In recent weeks, markets have lost some vigor amid renewed concerns about the economy. That could make it more difficult for big banks to raise additional capital. Banks also could face further losses as bad assets decline more in value.

On March 23, when Mr. Geithner unveiled PPIP, the Dow Jones Industrial Average surged nearly 500 points, or 7%, its biggest gain since October, on hopes that the program would nurse the banking industry back to health.

Many bank executives were skeptical about whether the program could succeed. Even before it was announced, some had grumbled that federal officials weren't consulting them, and instead were crafting the initiative with input from would-be investors. Some banking executives say they warned that they would be loath to sell at the kind of prices investors were likely to demand.

Executives at Citigroup Inc. shared those concerns, according to people familiar with the matter. While the New York bank was sitting on at least $300 billion of risky loans and securities, selling them at discounted prices would require painful hits to its already thin capital ratios, these people say.

Some Citigroup executives had a different idea: Maybe they could turn a profit by bidding on their own toxic assets at discounted prices, using government financing, according to the people familiar with the talks. Other big banks also talked about setting up distressed-asset units to snap up troubled loans and securities, including from their parent companies, with taxpayer financing.

FDIC Chairman Sheila Bair later publicly shot down the idea. Citigroup declined to comment.

Meanwhile, many small-town bankers hoped the program would help them unload the bad assets -- generally loans to finance commercial real-estate projects -- that were hurting their balance sheets. Some potential buyers had surfaced before PPIP was announced, but they were offering such low prices that few banks could afford to sell the loans without severely denting their capital cushions.

The hope was that PPIP would help narrow the gap between buyers and sellers. Investors would be able to bid more because the government would offer buyers little-money-down financing, along with some downside protection.

"We have illiquid assets," says Patrick Patrick, chief executive of Towne Bancorp of Mesa, Ariz. "It would be helpful to have a vehicle where you could sell them at market and be able to restructure our balance sheet."

Like many small banks, Towne Bancorp has been hurt by a handful of loans to finance real-estate projects that went belly up. In the first quarter, the bank said two souring commercial real-estate loans caused its portfolio of loans at least 90 days past due to swell by 52%. Such loans represent more than 22% of Towne Bancorp's $143 million in assets. The company has been trying for months to sell 19 pieces of real estate -- including undeveloped land and a warehouse -- that it seized when loans went into default.

When PPIP was announced, big-name investors were intent on figuring out how to profit from it. Raymond Dalio of giant hedge-fund firm Bridgewater Associates, which oversees $72 billion in assets, initially expressed interest in participating. But within days, he was blasting it, saying buyers and sellers would have difficulty agreeing on pricing and fund managers that profited would be exposed to criticism from politicians. The way PPIP is set up "makes us not want to participate and it makes us question the breadth of interest that we will see in the program," he wrote to clients.

Lawyers for hedge funds and private-equity investors warned clients about the risks of doing business with the government. The industry was unnerved by the restrictions placed on banks participating in another federal bailout program, the Troubled Asset Relief Program. Fund managers were also bothered by President Barack Obama's criticism of the hedge funds holding Chrysler LLC debt who had refused the government's buyout offers.

In conference calls with bankers and investors, FDIC officials emphasized that PPIP was critically important to cleanse banks of their bad assets. "I think you know the stakes are very high with this," Ms. Bair, the FDIC chairman, said during a March 26 call, according to a transcript. "We need this program to work."

Ms. Bair and her deputies encountered skepticism. In an April 9 conference call with the FDIC, Mark Wolf of TRI Investments LLC, described his Carlsbad, Calif., firm as a potential PPIP bidder. "Unless you've got a process that either forces banks to sell or does a better job of encouraging them to sell, we're just going to see banks sitting back and dribbling these things out through an eyedropper over the course of time," he said.

Some bankers were hesitant. "If these loans are bought at a discount, we create a hole in capital," Lou Akers, executive vice president of Adams National Bank in Washington, told FDIC officials on the March 26 call. He suggested that regulators consider changing the way they calculate banks' capital in order to cushion the blow. Government officials were noncommittal, a transcript of the call indicates.

FDIC officials emphasized on the conference calls that PPIP was intended to benefit all banks, not just industry giants. But smaller banks began to worry they'd be locked out.

To participate in PPIP, local lenders were told, they would have to pool their loans with other banks. The process, which the FDIC said it would facilitate, was designed to simplify the bidding process for government officials and prospective investors. The agency didn't want thousands of banks put their loan portfolios on the block separately.

But the FDIC planned to require participating banks to kick in a minimum amount of assets, and some small-town bankers worried they wouldn't have enough to qualify.

Too high a minimum "will virtually eliminate all community banks from being able to participate in this program," wrote Julian L. Fruhling, president of Legacy Bank in Scottsdale, Ariz., in a letter to the FDIC.

Still, some investment firms that were hoping to help manage the government's program were optimistic. Laurence Fink, chief executive of BlackRock Inc., said in mid-April during a trip to Japan that if his firm is selected as a manager, it was ready to raise $5 billion to $7 billion to buy securities through PPIP. He said he hoped to raise money from individual investors in Japan and the U.S., and that potential returns could be as high as 20%.

The FDIC and other regulatory agencies were planning to use their "stress tests" of the nation's top 19 banks to push them to sell assets via PPIP, according to people familiar with the matter. But in the weeks before the stress-test results were announced in May, market sentiment began to improve. A number of banks succeeded in raising capital by selling new shares to the public.

Once the stress tests were wrapped up in May, even more banks sold shares -- a total of roughly $65 billion within a month. The capital-raising removed regulators' leverage to encourage participation in PPIP, according to government officials.

Around the same time, BlackRock reduced its goal for the size of its potential PPIP investment fund to about $1 billion, say people familiar with the matter.

Earlier this month, the FDIC formally postponed the loan-buying portion of PPIP, called the Legacy Loan Program. "Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system," Ms. Bair said.

Next month, the FDIC intends to use PPIP for a far narrower purpose: to auction loans the agency has seized from failed banks. Eventually, it hopes to resuscitate the loan-buying program so that smaller banks can benefit from it.

But that could be tricky. The U.S. initially justified PPIP by invoking its "systemic risk" powers, which enable regulators to step in when the financial system is at risk. Regulators have debated whether such a justification would remain if the program were geared toward smaller banks. FDIC officials doubt they will muster the necessary consensus among regulators to invoke the special powers and keep the loan program alive, according to a person familiar with the matter.

Many banking experts contend that the financial system won't fully stabilize until banks get rid of their bad assets.

Mr. Segal, the bank adviser, complains that federal officials have cited recent capital raising by big banks as evidence that "the system is OK." That may be true "for the top 15 or 20 banks," he says. "But for everybody else, there really needs to be more attention paid."

[Wary Banks Hobble Toxic-Asset Plan]
—Deborah Solomon and Damian Paletta contributed to this article.

Saturday, June 27, 2009

Timelines of Policy Responses to the Global Financial Crisis

Posted on the New York Fed's website:

Over the past two years, and particularly since the intensification of the global financial crisis in the fall of 2008, new information has been released at a stunning pace. Between the breaking developments in the market and the vast array of policy responses both domestic and abroad, it has become increasingly challenging to understand the complex and evolving response to the crisis.

The Federal Reserve Bank of New York has produced several timelines to illustrate how events have unfolded. In both timelines, each event entry contains a link that takes you to the original government announcement or a recent news source for additional information.

The domestic timeline begins in June 2007, showing the lead-up to and development of the crisis as well as subsequent government responses. The timeline is divided into three sections: Federal Reserve policy actions, other policy actions, and market events. It provides an overview of the major turning points and shows how policy has responded to evolving market conditions.
Timeline >> pdf

The international timeline focuses on G-7 responses to the crisis since September 2008. It organizes announcements into four general categories: bank liability guarantees, liquidity and rescue interventions, unconventional monetary policy, and other market interventions. The entries are color-coded to allow you to follow the developments of each country individually. Timeline >> pdf

Thursday, June 25, 2009

Reform of regulation has to start by altering incentives

Posted in the Financial Times by Martin Wolf:

Proposals for reform of financial regulation are now everywhere. The most significant have come from the US, where President Barack Obama’s administration last week put forward a comprehensive, albeit timid, set of ideas. But will such proposals make the system less crisis-prone? My answer is, no. The reason for my pessimism is that the crisis has exacerbated the sector’s weaknesses. It is unlikely that envisaged reforms will offset this danger.

At the heart of the financial industry are highly leveraged businesses. Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely.

The place to start is with the core of modern capitalism: the limited liability, joint-stock company. Big commercial banks were among the most important products of the limited liability revolution. But banks are special sorts of businesses: for them, debt is more than a means of doing business; it is their business. Thus, limited liability is likely to have an exceptionally big impact on their behaviour.

Lucian Bebchuk and Holger Spamann of the Harvard Law School make the big point in an excellent recent paper.* Its focus is on the incentives affecting management. These are hugely important. Still more important, however, is why a limited liability bank, run in the interests of shareholders, is so risky.

In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses. In contemporary banks, leverage of 30 to one is normal. Higher leverage is not rare. As the authors argue, “leveraged bank shareholders have an incentive to increase the volatility of bank assets”.

Think of two business models with the same expected returns: in one these returns are sure and steady; in the other the outcome consists of lengthy periods of high returns and the occasional catastrophic loss. Rational shareholders will prefer the latter. This is what one sees: high equity returns, by the standards of other established businesses, and occasional wipe-outs.

Profs Bebchuk and Spamann add that four features of the modern financial system make the situation even worse: first, the capital of banks is itself partly funded by debt; second, the role of bank holding companies may further increase the incentives of shareholders to underplay risk; third, managers are rewarded for aligning their interests with those of shareholders; and, fourth, some of the ways managers are rewarded – options, for example – are themselves a geared play on rewards to shareholders. So managers have an even bigger economic interest in “going for broke” or “betting the bank” than shareholders. As the paper notes, the fact that some managers lost a great deal of money does not demonstrate they were foolish to make these bets, since their upside was so huge.

A solution seems evident: let creditors lose. Rational creditors would then charge a premium for lending to higher-risk operations, leading to lower levels of leverage. One objection is that creditors may be ill-informed about the risks being run by banks they are lending to. But there is a more forceful objection: many creditors are protected by insurance backed by governments. Such insurance is motivated by the importance of financial institutions as sources of credit, on the asset side, and suppliers of money, on the liability side. As a result, creditors have little interest in the quality of a bank’s assets or in its strategy. They appear to have lent to a bank. In reality, they have lent to the state.

The big lesson of the current crisis is just how far such insurance may go in the case of institutions deemed too big or interconnected to fail. Big banks rarely get into trouble in isolation: they often make very similar errors; moreover, the failure of one impairs the actual (or perceived) solvency of others. Thus, creditors are most at risk in a systemic crisis. But a systemic crisis is precisely when governments feel compelled to come to the rescue, as they did at the end of last year.

According to the International Monetary Fund’s latest Global Financial Stability Report, support offered by the US, UK and eurozone central banks and governments has amounted to $9,000bn (€6,400bn, £5,500bn), of which $4,500bn are guarantees. The balance sheet of the state was put behind the banks. This does not mean creditors bear no risk at all. But their risk is attenuated.

The well-known solution is to regulate such insured institutions very tightly. But an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the “shadow banking system” itself – was to find a way round regulation. The obvious question is whether it will be “different this time”. Sensible people must doubt it. Indeed, it must be particularly unlikely when the capitalisation of banks is so small. This is the time to go for broke.

In a speech delivered just last week, Mervyn King, governor of the Bank of England, made clear why finding a better approach matters so much: “The costs of this crisis are not to be measured simply in terms of its impact on public finances, the destruction of wealth and the number of jobs lost. They are also to be seen in the lost trust in the financial sector among other parts of our economy ... ‘My word is my bond’ are old words. ‘My word is my CDO-squared’ will never catch on.”

Such a crisis is not only the result of a rational response to incentives. Folly and ignorance play a part. Nor do I believe that bubbles and crises can be eliminated from capitalism. Yet it is hard to believe that the risks being run by huge institutions had nothing to do with incentives. The unpleasant truth is that, today, the incentive to behave in this risky way is, if anything, even bigger than it was before the crisis.

Regulatory reform cannot end with incentives. But it has to start from incentives. A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that.

Public support of banks

* Regulating Bankers’ Pay, Harvard Law and Economics Discussion Paper No. 641, May 2009

Tuesday, June 23, 2009

Put Options and Capital Adequacy, Evidence from the Options Market

Posted on RiskCenter by Donald R. van Deventer:

How much capital do four major bank holding companies need to be sure that their current market capitalization can be maintained through January 2011? This simple question was addressed by bank regulators in the U.S. using “stress tests” on the 19 largest bank holding companies in an intensive process between February and April 2009. Here we use public information from the options market for bank holding company common stock to get the same information in the view of market participants. We compare the results to the ranking of 4 of the 19 largest bank holding companies by ratings, by Kamakura default probabilities, and by the financing indicated by government stress tests as a percent of total assets.

In our blog post of May 7, 2009 (“Comparing Fed-Mandated Capital Needs with Default Probabilities and Ratings“), we showed that Kamakura Risk Information Services default probabilities had a much higher degree of consistency with stress-test-related capital needs than agency ratings. That small studied covered all 19 bank holding companies subject to the stress tests. Here, on a subset of that group, we add the insights on the subject of capital adequacy implied by put prices traded the bank holding companies’ common stock. We selected four companies from the group of 19 firms stress tested: American Express, Suntrust, Bank of America, and Wells Fargo. For each of the four firms, we compare stress test capital needs as a percent of assets, Standard & Poor’s rating, and default probabilities (“KDP” for Kamakura default probabilities) for 1 and 2 year maturities from the Kamakura Risk Information Services version 4.1 reduced form model.

Bank Holding Company Name

Ticker Symbol

Indicated Stress Test Capital Needs ($ billions)

Stress Test as Percent of Assets

1 year KDP, JC4, June 18, 2009

2 year KDP, jc4, June 18, 2009

Rating, June 18, 2009

Ratings Numerical Value

American Express Co.








Wells Fargo & Co.








Bank of America Corporation








SunTrust Banks Inc.








To this information, we add information from the market for common stock and put options on common stock. As we discussed in our blog post on May 13, 2009 (“Brother, Can You Spare a Dime or a Dollar? VAR versus the Put Option for Capital Allocation”), both Robert Jarrow and Robert C. Merton have argued that put prices are the best single indicator of total risk that a company possesses. The measure we seek to employ is the longest maturity put option price at a strike price equal to current common stock price, displayed as a percentage of the current stock price. This measure ensures that capital at the longest available put maturity will always be at the current market capitalization or greater. Barring any moral hazard prohibitions, this strategy could conceptually be implemented in the following way. First, calculate the cost of put options on all common shares outstanding at current market price, representing a total current market capitalization of $Y. We label the cost of the put options as amount $X. The bank holding company then issues enough additional common shares to buy put options on the original shares (which would have cost $X) and the new shares issued. The new shares represent additional market capitalization of $X and put options on them will cost $X times ($X/$Y). We compare the risk levels of these four bank holding companies by measuring the ratio of the cost of the put to the underlying common stock price at current market levels.

On June 19, the longest maturity put prices observable in the market place mature in January 2011, by coincidence spanning exactly the 2009-2010 period covered by government stress tests. Put prices are traded at “even” strike prices so we look at the nearest strike price above and below current common stock prices for all four firms. The common stock prices, put bid and offered prices, and calculated mid-market prices for the strike price immediately below the stock price is as follows:

Bank Holding Company Name

Stock Price, June 19, 2009

Lower Bound Put Strike Price

Lower Bound Bid Price

Lower Bound Offered Price

Lower Bound Mid-Market Price

American Express Co.






Wells Fargo & Co.






Bank of America Corporation






SunTrust Banks Inc.






The nearest strike price immediately above the current stock price, along with bid, offered, and mid-market prices, are given below:

Bank Holding Company Name

Stock Price, June 19, 2009

Upper Bond Put Strike Price

Upper Bound Bid Price

Upper Bound Offered Price

Upper Bound Mid-Market Price

American Express Co.






Wells Fargo & Co.






Bank of America Corporation






SunTrust Banks Inc.






Instead of invoking a “volatility smile” for estimating the price of a put option with a strike price exactly at market (an implicit admission that the Black-Scholes put model is mis-specified), we do a simple linear interpolation of the put prices from the “even” strike prices above and below the current market price. The interpolated put prices and their ratios to current stock price are given in this table:

Bank Holding Company Name

Stock Price, June 19, 2009

Interpolated Put Cost with Strike at Market Price

Interpolated Put Price as Percent of Market Price

American Express Co.




Wells Fargo & Co.




Bank of America Corporation




SunTrust Banks Inc.




The table shows that American Express has less total risk than the other three firms, because the cost of insuring that market capitalization (in terms of today’s stock price) stays at or above current market levels is a smaller percentage of current market capitalization (25.74%, calculated as the put price/common stock price) than it is for the other three firms. SunTrust, by the Merton-Jarrow risk index, is the riskiest with a ratio of put price to stock price of 32.77% for a January 2011 maturity.

How does this result, which takes about 5 minutes to calculate for each bank, compare with ratings, KRIS default probabilities, and government mandated stress tests? The table below shows the correlations between each of these risk indices for our small sample of banks: In calculating correlation, we converted ratings to an ordinal number with AAA as 1, AA+ as 2, and so on.

Put as Percent of Market

1 Year KDP

2 Year KDP

Stress Test as Percent of Assets


Put as Percent of Market






1 Year KDP






2 Year KDP






Stress Test as Percent of Assets












The put price ratio had a 73.8% correlation with government-mandated stress tests, compared with an 88% and 90% correlation with stress test results for the 1 year and 2 year Kamakura default probabilities (“KDP”). Ratings, by contrast, on this small sample had a negative correlation of 40.8% with government stress test results when one would have expected a strongly positive correlation.

The purpose of this post is to show that the put option approach to risk assessment is practical, fast, and highly accurate when compared either to government mandated stress test results or Kamakura default probabilities. On this small sample, the same could not be said for agency ratings.

The Shadow Banking System That Operated In Broad Daylight: Part I

Posted on Derivative Dribble by Charles Davi:

Mark Thoma and Brad Delong are completely entrenched into the position that this crisis was brought on by the nefarious “shadow banking system.” In fairness to Thoma, he is trying quite sincerely to argue his point, and I think my disagreement with him stems mostly from my objection to labeling particular aspects of the financial system as “shadow banking.” That said, I do take issue with a few of his substantive points. Rortybomb does a fine job summarizing the recent history of this debate, highlights some of the strengths of Thoma’s position, and also clarifies the debate by providing a reasonable framework for what it is that people are referring to when they talk about the “shadow banking system.”

As for Delong, his argument takes the form of an excursion through unmitigated nonsense, as he boasts his deep knowledge of comic books, and little else. As such, in this post, I’ll begin with Delong’s argument, since it is completely unfounded. In the next post, I’ll take on Thoma’s position, as it warrants more attention and represents an opinion held by a lot of intelligent people. I just happen to disagree.
So here goes Delong:

[C]ommercial banks–with their massive retail savings deposits–have for the most part come through this all right. In fact, the possession of lots of inertial commercial savings and checking deposits that they did not have to worry might flee provided JPMorgan (with the retail banking assets of Chase) and the bank formerly known as NationsBank (with the retail banking assets of Bank of America) with competitive advantages that allowed them to pick up the assets of Bear Stearns and Merrill Lynch at what they thought were bargain prices.

Wow, those are some seriously important-sounding terms there. We’ve got “massive retail savings deposits,” “competitive advantages,” and don’t forget those “inertial commercial savings and checking deposits.” How could deposit taking banks fail with all that going for them? Surely, deposit taking banks are doing swell! And, they are, with the noted exception of the seemingly endless list of failures that have occurred at deposit taking banks over the last 2 years. But there are even more inconvenient aspects of the observable universe that Delong must tackle before we can accept his deposits-cure-all theory of banking. For example, U.S. banks and bank holding companies are currently receiving all kinds of direct and indirect support from the U.S. government through the alphabet soup of liquidity and guarantee programs that have been set up since the crisis got underway. Also, it is my understanding that European banks, while more leveraged than their U.S. counterparts, rely much more on deposits than U.S. banks do. Yet, the European banking system is suffering a crisis that rivals our own by several measures.

Delong’s position seems to be just another manifestation of the idea that, somehow, good old fashioned banking is the answer. Deposits and lending, and that’s it. None of this fancy stuff. That has a nice ring to it. It’s sentimental, makes us think that our parents are smarter than us, and it has an almost sanctimonious aspect to it, in that it suggests that if we part with some of the more luxurious aspects of finance, we can have some more stability. However, history has a few counterexamples to this position, one being the Great Depression.

While others chalk this crisis up to SIVs, CDOs, and a bunch of other acronyms they really don’t understand, I see it in much simpler terms: banks, and others in the financial system, all made the same bad bet based on unsustainable assumptions. Sure, some of them made this bet using sophisticated means, and that itself is a topic worth exploring. But the root cause of all of this, in my opinion, is underestimating risk. This underestimating had heavy assistance from some very regulated entities and markets. As such, I reject the argument that the “shadow banking system” caused this crisis for two reasons: first, everyone that mattered and could do something about what was going on knew full well what was going on. So how is it productive to ascribe such a mysterious sounding name to something that people were fully aware of? And second, the root cause of this crisis is, in my opinion, much easier to grasp once we reduce all of the complexities to simpler constructs, and think in terms of what risks entities and markets were exposed to, and for that limited purpose, ignore the means by which they were exposed to those risks.

LIBOR is useless


Much has been made of Libor’s recent descent to post-Lehman crisis lows. But while some say it marks the return of a healthy interbank lending market, others — rising in number by the way– appear to see it as evidence of Libor’s growing irrelevance.

LIBOR-OIS spread - Bloomberg

Chief among the “Libor is useless ” brigade is Zerohedge blogger Tyler Durden. He writes in a recent post:

…in true pro-cyclical fashion, the expectation for permanent governmental crutches can be best seen in some of the same metrics that in the post-Lehman days markedly went off the charts, most notably the LIBOR rate. From record wides several months ago, LIBOR, which is critical as it is the reference risk rate for trillions in assorted product classes, has collapsed to an unprecedented low. The rate drop has manifested in an inversion of the 1 Yr UST - 1 Yr LIBOR spread, with the latter clearing 100 bps inside of the former: a topic covered in detail previously by reader Gary Jefferey.

He further points us to news that the British Bankers’ Association (BBA), which sets the daily rate, is looking to expand the list of banks contributing quotes to the daily fixing due to the mergerfication of its 16-standing members. As the WSJ notes:

Currently there is no good alternative to LIBOR, although the Overnight Index Swap (OIS) is trying to replace it with limited success. So, the marketplace is searching for an alternative with many banks attempting to devise their own measures to varying degrees of success.

They go on:

World central banks have used the Term Auction Facility (or TAF) in a heavy-handed way to suppress LIBOR. They are doing this because virtually all subprime adjustable rate mortgages (ARMs) are reset using LIBOR. In other words, world central banks are subsidizing shaky mortgages by artificially lowering the reference rate used to reset rates every year. The problem is banks are not happy with the effect this has on other lending and are looking for alternatives. So in a nutshell, yes, central banks have successfully driven down Libor rates thanks to the Fed’s TAF facility. This is good because most subprime adjustable rates are linked to Libor. Great joy. However, as far as encouraging banks to lend again, that might be an entirely different story.

Banks are seeking out alternatives to low Libor rate because they’re clearly still unconvinced by talk of an imminent recovery. They still want to protect new lending with deals linked to alternative rates, more reflective in their minds of the premium needed to cover their risk exposure.

The BBA’s move, meanwhile, is a case of adapt or die. The manoeuvre clearly hopes to prove Libor is still relevant to the market, but actually shows off more concerns about its use as a floating-rate benchmark in the future than anything else.

In which case, while low Libor rates might be a good indicator for prospective default rates, as far as indicating a return to normal interbank lending practices, they may be very misleading. In this respect it’s perhaps better to look at issuance of commercial paper - the lifeline of business financing, which certainly isn’t as optimistic. For one, note the following chart from the the St. Louis Fed showing current commercial paper outstanding to nonfinancial companies in the US:

Commercial paper - St. Louis Fed

As can be seen, there’s hardly been any pick-up in issuance since the post-Lehman phase of the crisis took hold — this despite the epic fall of Libor. Lending to business remains - in no uncertain terms - firmly crunched.

As the Pragmatic Capitalist noted last week:

The deceleration in commercial paper has had a very high correlation with economic activity in the last two years. The recent cliff dive in commercial paper represents how weak near-term business activity has been across the economy. I would expect to see a substantial acceleration in the ABCP market before we see any sharp acceleration in economic activity. As of now, the commercial paper market is nothing more than a sure sign that the so called “recovery” is beyond weak and is perhaps even weaker than many “green shoot” theorists assume. A double dip recession is looking more and more possible as we move into the second half of the year…

Thursday, June 18, 2009

BBA to let non-London banks participate in Libor

Posted on Reuters:

The British Bankers' Association said on Thursday it will change its definition of the London
Interbank offered rate (Libor) to allow a greater number of institutions to participate in the daily rate fixing process.
Libor rates represent the average cost at which a panel of banks believe they can borrow funds for various periods of time
in various currencies.

Currently the definition refers to rates formed in London. The amendment, to be announced and implemented by the BBA on
Friday, will allow the submission of rates from banks participating in the London market but without a physical base
in the city.
The change will allow the BBA to expand the number of banks contributing to its fixing panels and will also mean that banks
that are for example, ceasing London operations, can continue to contribute, the BBA said.

Buffett and Derivatives: Enthusiasm, Anger, Disbelief, Acceptance

Posted on Paul Wilmott's Blog:

Denial, anger, bargaining, depression, acceptance, according to Elizabeth K├╝bler-Ross the five stages of dealing with personal tragedy. I wonder if there's something similar we are going through with financial derivatives? If so, I think Warren Buffett is at the anger stage. "If you need to use a computer or a calculator to make the calculation, you shouldn't buy it," is his view on investing, famously calling derivatives "Weapons of mass destruction" a few years ago. I sympathize, and I speak as one of the mathematicians who works with derivatives for a living.

In my experience there are just four stages of dealing with derivatives, and they are: naive enthusiasm, as one experiences the glorious possibilities of derivatives in one's portfolio, then righteous anger as one suffers horrendous losses, followed by confused disbelief, as one realises that no one fully understood the risk in these dastardly creations, least of all the bankers, and finally a reluctant acceptance as one admits that these things are here to stay. Let's go through these stages one by one, while I explain what each means in terms of risk.

Naive enthusiasm: Derivatives are wonderful financial contracts, they allow you to finely tune your investment portfolio to benefit from your market views, assuming they turn out to be correct. My bank manager has recently been trying to sell me a contract that will give me over 5% return in one year if gold stays within a certain trading range. In market parlance this is called a double knockout quanto option. Or derivatives can be used to hedge risk from other business activities. If you regularly sell widgets to Japan you are exposed to dollar/yen exchange-rate risk. A derivative can be designed to reduce that risk for you. So far so good.

Righteous anger: Who wouldn't be angry after the trillions of dollars that have been lost thanks to CDOs, MBSs, and all the other acronyms? The problem though is not the derivatives themselves, rather the way that the derivatives have swamped the market for simple stocks and shares. The notional outstanding of all derivatives globally is over a quadrillion dollars. What, you thought trillions was bad enough? You, ain't seen nothing yet!

So rather than derivatives existing to help you manage risk, or profit from precise market views, the market has grown so much that derivatives seem to be there just to allow crazy leverage, risk taking on levels never seen before. And at this point the risk-management quants step in to say, don't worry we've got our fancy mathematical models that show there is actually no risk.

Buffett's right-hand man, Charlie Munger, has said about higher mathematics in finance "They teach that in business schools because, well, they've got to do something." Now that really hits the nail on the head. When your competitor university across the river is charging 50, 60, 70 thousand dollars for a one-year Masters course in Financial Engineering, what are you going to do? Are you going to say you don't have any faculty that understand derivatives? Hell, no. You are going to get your smartest mathematicians together and make up a syllabus. Are your 23-year old victims, sorry I mean students, going to know any better? In 2000 I warned about the dangers of a "mathematician-led market meltdown" after seeing what had happened at LTCM and how identikit risk managers were being churned out from Masters programs, and how Groupthink was beginning to dominate risk research and derivatives valuation. I sympathize totally with Warren Buffett and Charlie Munger.

Confused disbelief: I'm a great believer in education playing a bigger role in derivatives in future. But not the sort of education that we've got at the moment. I understand Warren Buffett when he says "The more symbols they could work into their writing the more they were revered." Universities are churning out many thousands of 'experts' in the analysis of derivatives but sadly they know more about the math and the symbols than they do about the markets. But again it's not the symbols themselves that are to blame, for we happily fly on airplanes designed using similar symbols, rather it's the lack of financial empathy exhibited by the multiple-PhD'd analysts, the quants, that worries me. Remember this is a mathematician writing this, but one who has been saying less is more for over a decade now.

Reluctant acceptance: I've blogged in the past about the "mathematics sweet spot" for finance, where the models are not dumbed down, but equally they are not fantastically over complicated (to impress, as I expect Buffett would say). I don't think we can go back to a dark ages before derivatives and quantitative finance, but I do believe that we desperately need to rethink the type of education that those 23-year olds, soon to be in charge of your pension, are getting. Less math, fewer symbols, more commonsense, and more market know-how.

And in this respect I think I'm a few stages ahead of Mr Buffett.

Wednesday, June 17, 2009

Financial regulation: The alphabet soup gets much worse

Posted on Reuters by Felix Salmon:

Do you know a FHC from a BCBS? If not, you’re going to have a hard time wading through the government’s white paper on financial reform, which is full of such things. (An FHC is a financial holding company; the BCBS is the Basel Committee on Banking Supervision. The link is to the WaPo leak of the paper, there might be minor changes in the final document.) This, for instance, is a real sentence from the paper:

The United States will work to implement the updated ICRG peer review process and work with partners in the FATF to address jurisdictions not complying with international AML/CFT standards.

But never fear! Your tireless blogger has waded through all 85 pages, and I’m pretty sure I’ve got the gist of it at this point.

In a nutshell: If you thought this was going to make the current horribly-complicated system of financial regulation less complicated, think again.

And so to the specifics. Were you hoping that the present alphabet soup of regulators would get rationalized and downsized? I know that I was. But there’s only one place that’s going to happen: the OCC and the OTS are going to be folded into a new regulatory entity called the National Bank Supervisor (NBS), which (along with the Fed, natch) will oversee federally-chartered banks.

The National Bank Supervisor will not oversee state-chartered banks: those will remain under the umbrella of the FDIC, which is not being folded into the NBS. And the NBS will similarly not oversee credit unions: the NCUA will retain its independence and continue to regulate those itself.

Why perpetuate these distinctions between federally-chartered banks, state-chartered banks, and credit unions? I have no idea. But in order to get some measure of cohesion over all this, a second brand-new regulatory entity, the Financial Services Oversight Council, or FOSC, which will consist of the leadership of the NBS; the FDIC; the NCUA; the SEC and the CFTC (yes, they are remaining separate too); the FHFA (that, too, gets to remain independent for no obvious reason); the Treasury; the FOMC; and the brand-new Consumer Financial Protection Agency.

Or, to put it another way, FOSC = NBS + FDIC + NCUA + SEC + CFTC + FHFA + FOMC + CFPA + Treasury.

I know what you’re thinking — it can’t possibly be as simple as that. And you’d be right! There’s also a Financial Consumer Coordinating Council, which comprises the Consumer Financial Protection Agency, the Federal Trade Commission, and the SEC’s Investor Advisory Committee.

Oh, and I almost forgot, they’re also creating an Office of National Insurance.

In other words, if you thought the bureaucracy was bad until now, just wait until you see what’s coming down the pike.

Which is not to say that there aren’t any good ideas in this white paper. I like the fact that the CFPA will have the power to conduct Community Reinvestment Act examinations, for instance, and I love the fact that stockbrokers will — finally — have a fiduciary responsibility to their clients. The Obamacrats have also managed to sneak in legislation forcing opt-out, rather than opt-in, retirement plans for corporate employees.

But there are weaknesses here, too, and not just at the org-chart level. Treasury has decided that no financial institution can be allowed to engage in any nonbanking activities at all — basically there’s no way that Walmart, for instance, or Safeway, will ever get a banking license. That’s bad for consumers.

The white paper also punts on trying to clear up the mess of conflicts between the SEC and the CFTC: it basically just tells the two agencies to go away and work it all out on their own.

And the new extra-stringent regulations on what the white paper calls “Tier 1 FHCs” — the systemically-important financial institutions — don’t seem particularly stringent to me. For instance, there’s this:

Tier 1 FHCs should be required to have enough high-quality capital during good economic times to keep them above prudential minimum capital requirements during stressed economic times.

This sounds good, until you realize that exactly the same language is used with respect to all banks, and bank holding companies, a couple of pages later.

But the main message of this white paper (and I’m sure Congress will do all manner of mischief to it before anything gets passed into law) is that there aren’t any problems of financial regulation which can’t be solved by setting up a high-level committee. In other words, it’s a bust.

Monday, June 15, 2009

Today’s Foundation, Tomorrow’s Crisis: The Geithner-Summers Proposals

Posted on the Baseline Scenario by Simon Johnson:

Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation.

The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.

  1. Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.
  2. Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator. Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large - higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.
  3. Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors. Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage. What prevents the biggest banks from capturing or manipulating regulators? There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.
  4. Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.” Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.
  5. Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.” This sounds incredibly vague and may be the worst news today. It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.

And of course the complete omissions from this document are breathtaking. No mention of executive compensation or the structure of compenstion within the financial sector. Not even a hint that the complete breakdown of corporate governance at major banks contributed to execessive risk taking. And no notion of regulatory capture-by-crazy-ideas of any kind.

There are a couple of positive notes towards the end. The administration will seek a resolution authority for dealing with failed banks, but we knew this already. And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.

Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office.

Sober Look - TALF is Giving ABS a Nice Ride

Posted on RiskCenter.com by Walter Kurtz:

Asset-backed securities (ABS) have experienced an unprecedented rally recently. Here we are going to look at ABS as bonds collateralized by receivables from credit cards, auto loans, auto leases, equipment leases, and student loans (as opposed to any real estate linked collateral.) The recent rally (collapse in spreads) is getting us back to the pre-Lehman levels. Effectively the "Lehman premium" in credit has been taken out.

This is indeed a positive development for the consumer. To the extent the US consumer is willing to maintain or add leverage, it's going to cost less (assuming the lenders can pass on their savings to the consumer). Such a rally must indicate a new source of demand for paper. Well, it's coming from the tax payer via TALF. The chart below shows ABS issuance via private funds, vs. TALF transactions. TALF-based financing is driving the new demand.

For more info on TALF, please see our post on the issue. So the taxpayer is financing this stuff and the question remains whether there will be a home for this paper in the post-TALF world. The good news is that the taxpayer holds the most senior claim and has much more subordination (down payment from investors) than senior lenders did in the past. Below is a chart prepared by Morgan Stanley that compares Harley-Davidson motorcycle loan receivables securitization pre-crisis and post-crisis with TALF.

The green portion is the AAA tranche that in the past would have been bought by investors/banks who used commercial paper conduits (topic for a later discussion) to fund these. Now the government lends against the AAA tranche that has a far bigger cushion (the gray section) than in the past (yellow and blue). This is to a large extent due to rating agencies trying to correct for their past mistakes, making much more conservative assumptions about defaults. Now that the tax payer (via the Fed) is loaded with this debt (in addition to all the other debt the Fed is buying), let's hope we can-forgive us-ride it out.

New Financial Foundation (Geithner and Summers in the Washington Post)

Posted in the Washington Post by Timothy Geithner and Lawrence Summers:

Over the past two years, we have faced the most severe financial crisis since the Great Depression. The financial system failed to perform its function as a reducer and distributor of risk. Instead, it magnified risks, precipitating an economic contraction that has hurt families and businesses around the world.

We have taken extraordinary measures to help put America on a path to recovery. But it is not enough to simply repair the damage. The economic pain felt by ordinary Americans is a daily reminder that, even as we labor toward recovery, we must begin today to build the foundation for a stronger and safer system.

This current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation.

Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.

That is why, this week -- at the president's direction, and after months of consultation with Congress, regulators, business and consumer groups, academics and experts -- the administration will put forward a plan to modernize financial regulation and supervision. The goal is to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess.

In developing its proposals, the administration has focused on five key problems in our existing regulatory regime -- problems that, we believe, played a direct role in producing or magnifying the current crisis.

First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.

The administration's proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve, and we will establish a council of regulators with broader coordinating responsibility across the financial system.

Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.

The administration's plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors' and regulators' reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.

The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of "over the counter" derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse.

Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products -- from credit cards to annuities.

Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board.

Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve's lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term.

To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.

Fifth, and finally, we live in a globalized world, and the actions we take here at home -- no matter how smart and sound -- will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world.

The discussion here presents only a brief preview of the administration's forthcoming proposals. Some people will say that this is not the time to debate the future of financial regulation, that this debate should wait until the crisis is fully behind us. Such critics misunderstand the nature of the challenges we face. Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery.

By restoring the public's trust in our financial system, the administration's reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses. Now is the time to act.

Saturday, June 13, 2009

Claim or Interest -- part 1

Posted on Credit Slips by Stephen Lubben:

One of the key disputes in both the GM and Chrysler cases has been the use of §363(f) to sell the assets "free and clear" of successor liability claims. The normal rule is that a corporation that buys another corporation's assets does not buy its liabilities, unless it expressly contracts to do so. In this context, successor liability typically refers to the "product line" exceptions developed by the California and Michigan Supreme Courts, that allow the assertion of product liability claims against the buyer, notwithstanding the normal rule.

The primary argument against the debtor's ability to sell its assets free of the plaintiff's ability to assert a successor liability claim against the buyer is that §363(f) refers to sales free of an "interest in such property," while §1141, the chapter 11 discharge, relieves the debtor of "claims and interests." For example, in the objection to the Chrysler sale filed by the "tort claimants and consumer organizations," it was argued:

Moreover, the language of Section 1141 of the Bankruptcy Code confirms the propriety of a narrow reading of Section 363(f). Section 1141, which governs the disposition of estate property in a plan of reorganization, broadly states that property dealt with in a plan is free and clear of all “claims and interests of creditors.” 11 U.S.C. § 1141(c). This language is much broader than that of Section 363(f) by including “claims”, not just “interests in property,” i.e. liens.

I do not find the comparison of these two provisions particularly helpful, because it seems clear that the word "interest" is used very differently in the two sections. Indeed, the Bankruptcy Code uses the word "interest" or variations thereof (e.g., disinterested) more than 300 times, often in very different contexts. The most obvious example being interest paid on a debt, e.g., §362(d)(3)(B), a use which would seem to be of little relevance to this discussion.

In §1141(c), confirmation of a plan means that "the property dealt with by the plan is free and clear of all claims and interests of creditors, equity security holders, and of general partners in the debtor." In the this instance, it seems clear that "claims" corresponds with "creditors," while "interests" corresponds with "equity security holders" and "general partners."

Shareholders and general partners do not have claims -- so "interest" as used here must refer to them. This also corresponds with the use of "interest" to mean "ownership interest," which is seen in several other parts of chapter 11, like §1129(a)(7), where the use is "class of interests" and 1129(b)(C), which again talks about a "class of interests." Section 101(16)(B) also defines "equity security" to include the "interest" of a limited partner in the partnership. And section 1141(d)(1)(B) confirms this reading by further providing that confirmation of the plan "terminates all rights and interests of equity security holders and general partners." (emphasis added).

Section 1124 also refers to a class of "claims or interests," and here the "or" would seem to create a problem if "interest" meant "lien," as the tort claimants suggest. How does one put a lien -- divorced for the underlying "claim" -- in a class? Senate Report 95–989, which described §1124 as part of the Code's enactment in 1978, further drives home the point that "interest" corresponds with "equity," while "claim" corresponds with "debt" by explaining that

a claim or interest is unimpaired if the plan provides for their payment in cash. In the case of a debt liability, the cash payment is for the allowed amount of the claim, which does not include a redemption premium . . . With respect to any other equity security, such as a common stock, cash payment must be equal to the “value of such holder’s interest in the debtor.” (emphasis added).

In short, it is clear that "interest" as used in §1141, and many other places in chapter 11, does not mean "lien." In chapter 11 "interest" frequently refers to an "ownership interest."

That being said, just because the tort claimants have made a faulty comparison with §1141, it does not necessarily follow that §363(f) allows the sale free of a right to assert a claim against the buyer of the debtor's assets. Instead, the foregoing simply suggests that we can't conclude anything from Congress' failure to include the term "claim" in §363(f) while including it in §1141.

In my next post on this topic, I'll proceed to examine §363(f)'s use of "interest," which I think we can agree clearly does not mean simply "ownership interest," as in §1141. On the other hand, I will argue that it means more than "lien," as the tort claimants have argued.