Wednesday, October 7, 2009

Why Sheila Bair’s Remarks about Repos are Really, Really Important

Posted on RGE by Joseph Mason:

While much is being made of Sheila Bair’s recent comments on haircuts to secured lenders, the Chair of the FDIC seems, to me, to be trying to expand the discussion of problem bank resolution in a constructive manner. Other regulators, so far, have shied away from real policy reforms that deal with too-big-to-fail in any meaningful economic sense. The FDIC, however, is trying to eviscerate some old policies that have been more and more troublesome with each passing crisis and at the same time lay down some resolution principals that can carry over to the next crisis. Let’s take a hard look at what she may really be proposing in more detail.

Recall that Bloomberg reported yesterday that, Federal Deposit Insurance Corp. Chairman Sheila Bair said regulators should consider making secured creditors carry more of the cost of bank failures. “This could involve potentially limiting their claims to no more than, say, 80 percent of their secured credits,” Bair said in a speech to a banking conference in Istanbul [on October 4]. “This would ensure that market participants always have some skin in the game, and it would be very strong medicine indeed.” …Bair, while acknowledging her proposal could increase borrowing costs for banks, said it might encourage them to reduce their reliance on short-term funding while making the broader financial system more resilient. She also said it might reduce the burden of a failure on unsecured creditors, who would then be less likely to press for a government bailout. (Rebecca Christie, “Bair Says Secured Creditors Should Help Pay for Bank Failure,” 2009-10-05 02:18:31.923 GMT)

While the Bloomberg piece was in introduction to the debate, in order to properly understand the weight of Ms. Bair’s remarks, you really have to understand the dynamics of the meltdown. Few people, however, still understand what happened in the grander scheme.

In the years leading up to the crisis there was a growing reliance upon market funding the entire mortgage origination pipeline, taking the entire operation off of many bank balance sheets, just as non-bank “mortgage bank” monoline (non-bank bank, not financial guarantors) financial institutions worked without that balance sheet to begin with.

The idea became to finance short-term day loans to lenders on a daily basis, which were repaid upon selling the loans into several-week repo commitments as longer-term warehousing and, later, monthly securitizations as more permanent funding. The short story of the crisis is that securitization was evaporating all through 2007 leading to increased margin calls on repo warehouse funding, and the eventual shutdown of day loans at various times (depending on which institution you are talking about) before Lehman, with Lehman marking the end of the road for everyone.

The key to the arrangements was increased acceptance of repo funding by commercial banks and other mortgage originators, as well as bankruptcy courts, in the past decade. In an April 22, 2009 Viewpoint piece written for Dow Jones DBR Small Cap, Julia Whitehead explains succinctly:

…the measures now causing so much distress for the industry were rooted in a desire to protect markets from the snowballing impact of the bankruptcy of a large player. Back in 1978, when the Bankruptcy Reform Act modernized Chapter 11, the initial expression of this concern was limited to protecting pre-bankruptcy margin payments on commodity transactions from clawback by a debtor's estate.

…By 2005, the enormous growth of financial markets, particularly those involving complex swaps and derivatives which had never experienced the bankruptcy of a big counterparty, caused industry leaders to grow queasy that a filing by a large enough player could cause systemic damage. By that time also, the conclusion that counterparties' ability to close out their exposures to Long-Term Capital Management had saved the market from the collapse of that firm was gaining traction. The convergence of those thoughts propelled BAPCPA's extension of safe harbor provisions to a seemingly unlimited universe of financial contracts and dramatically increased the number of parties who could freely terminate or accelerate agreements, liquidate positions, and set off claims against margin or collateral called in from a debtor without fear of interference by a bankruptcy court. BAPCPA provided new powers as well through its inclusion of the so-called "master netting agreement", which allowed counterparties to exert all these bankruptcy- protected actions across multiple contracts and products, a response to the belief that the more players were able to net down their all exposures free of Chapter 11 constraints, the less exposed they and the markets would be to travails of a major participant.

…American Home Mortgage's bankruptcy illustrated some of these problems. The firm filed after failing to meet the second of two margin calls from Lehman under a master repurchase agreement secured by mortgage-backed securities which were foreclosed on by Lehman after the bankruptcy filing. American Home subsequently argued that not only were the margin calls fabricated (their own valuation of the mortgage securities being substantially higher than Lehman's), but that the repo was really a secured lending agreement with some extra language thrown in simply to allow Lehman to take advantage of BAPCPA's safe harbor protections for repo agreements.

…It is no surprise, even, that the totality of these demands could completely overwhelm whatever liquidity reserves a hapless company thought it would need to cover the most draconian calls, and helped to push Bear Stearns and AIG into government-assisted rescues and Lehman Brothers right through the Chapter 11 door.

…While once firms moderated their collateral demands lest they individually or collectively push a weak counterparty into a bankruptcy that could pull back that collateral and take years to resolve, with BAPCPA's safe harbors, counterparties are incentivized to grab whatever they can as fast as they can; if they don't someone else surely will and who wants to be the only one fighting it out as an unsecured creditor in Chapter 11? [emphasis added]

So what the FDIC is struggling against is really a violation of absolute priority, memorialized by BAPCA, that puts traditional bank assets squarely out of the reach of the deposit insurer. The FDIC is now standing behind these margin claims, liquidating banks that have no assets left in them after repo counterparties bleed them dry of collateral and dealing with counterparty fallout among commercial banks with claims behind the repo collateral.

The confusion about Ms. Bair’s comments, therefore, is partially a cause of both a misunderstanding of the crisis and a desire to continue forward with the massive interruptions caused by BAPCA. Whether you look into the consumer bankruptcy effects described by Michelle White or the corporate bankruptcy effects described by Julia Whitehead, the inescapable conclusion is that BAPCA changed many moving parts of bankruptcy law broadly in favor of private creditors, the economic effects of which are still largely out of balance.

The FDIC has to deal with its own ramifications of BAPCA and the contracts the law incentivized. Just as the mortgages that contributed to the credit crisis were not your parents’ mortgages, the repos Bair discussed are not the traditional products you think of in repo markets. These repos were market funding products that resulted in the manifestation of “cliff risk,” where the entire financial market seemed to suddenly blow up in 2007 and 2008. Of course, had we known where to look we could have seen the pressures mounting, just as Ms. Whitehead describes in the experience with AHM, Bear, Lehman, and others. While those of us who have been inundated in investigations of the phenomenon – whether for legal case work, regulatory rulemaking, or academic research – now understand the dynamics, the popular reactions to Ms. Bair’s remarks shows that many market observers and policymakers are still in the dark. Worse yet, policymakers are relying on more margining as a fix for systemic risk from OTC derivatives, threatening more – not less – sudden failures like we saw at the peak of the panic.

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