Cezary Salad

Open up any paper today and you’re sure to read something along the lines of “the government’s leverage over US banks is weakening” because so many of them are exiting the Troubled Asset Relief Program (aka the bailout fund). With Citi and Wells Fargo announcing within hours of each other that they will be paying back their bailout packages, the banking sector as a whole will have paid back $161 billion of the $245 billion it received from the bailout fund, according to the Wall Street Journal.

To be sure, there is no denying that by repaying their bailout funds the banks are freeing themselves from the kind of scrutiny and tight control over pay and perks that comes with being a taxpayer-supported entity.

But let’s not kid ourselves: the US never really had much - if any - leverage over the banks it bailed out. I realized as much last week when I went to hear William Dudley, President of the Federal Reserve Bank of New York and a key behind-the-scenes player for bailout of insurer AIG, speak at my university (video available on the Columbia World Leaders Forum website).

Think back to September 2008. When Fed Chairman Ben Bernanke and former Treasury Secretary Hank Paulson went to Capitol Hill to ask Congress for the bailout funds, their rationale was simple: the very existence of the US financial system is at stake. As Dudley put it:

“The choice that faced us was financial Armageddon or saving the financial system. It was a choice between two bads and we picked what we thought was the less bad. But it wasn’t a great outcome - we agree with that.”

The reason it wasn’t a great outcome, of course, is that there was seemingly no way to separate saving the financial system from saving the financiers who nearly felled it. As a recent inspector general report uncovered, the US Treasury made its initial $85 billion loan to AIG last year knowing full well that substantial chunks would be used to make payments to the bankers it dealt with - i.e. Société Générale, Goldman Sachs, Merrill Lynch, Banc of America, among others.

Providing the loan was necessary to avoid the aforementioned Armageddon. But it also resulted in the so-called “backdoor bailout” of these banks, as they got their money and they got it at 100 cents on the dollar. So now that many of them are doing better and have either awarded or are about to award billions of dollars in taxpayer-funded bonuses, “wasn’t a great outcome” is putting it lightly.

Dudley acknowledged as much; he said multiple times that this was unfair, adding “if there were some way that we had the tools to save the financial system and not save the bankers, that would have been a better way to go. But we didn’t have that choice.”

New York Times columnist Paul Krugman thinks they did. In a scathing November 19 editorial, he accused the Fed of treating the financial industry with “kid gloves” because Dudley and his team did not exact concessions from the bankers who got AIG’s - rather, the taxpayers’ - money.

Krugman’s “kid gloves” comment was on my mind when I asked Dudley why he couldn’t wrestle even the slightest concession from, say, Goldman Sachs. After all, the investment bank held a call with business reporters in early March to say, in essence, that it had hedged its bets well enough that it did not need the $13 billion it received from AIG. Dudley was curt in his answer:

“If you’re preventing a bankruptcy, you’re supporting all the counterparties. You cannot pick and choose. And so whether Goldman Sachs was well hedged or not was immaterial.”

In other words, at the point when you say, “we’re going to avoid a bankruptcy,” you lose your leverage. The normal rules of the financial system apply and everyone gets paid what they’re owed, as opposed to a bankruptcy situation, where the senior creditors would have gotten their money first and counterparties like Goldman would likely have ended up empty-handed.

“To put it starkly, power in a negotiation comes either from being able to issue a credible threat or from coercion,” Dudley said in his prepared remarks. He freely admitted that the Fed clearly had neither tool at its disposal.

And so the financial system was saved - as were the bankers.

Lesson learned? Well, if the US gave $85 billion to an insurance company that then went on to post a world record $61.6 billion quarterly loss and reward the executives responsible for the loss with bonuses, that doesn’t say much about our ability to attach strings to bailout funds to limit these not-so-great-outcomes. Indeed, as with AIG, so with the other TARP recipients, who took when they needed and haven’t much changed their behavior.

And why should they? To paraphrase Dudley, power in negotiation comes from leverage. And the only leverage the US has these days is $12 trillion in national debt.

It’s rare to pick up the paper on the way to lunch with someone and find a story that prepares you precisely for the conversation you’re about to have. But that’s what happened to me a few days ago when I read the New York Times on the way to a lunchtime meeting with Ed Grebeck.

Grebeck specializes in a subject of great interest to me – structured finance– and we were meeting to discuss how, more than two years after the outbreak of the financial crisis, not much, if anything, had been done on the regulatory front to make sure that the mistakes of the past don’t happen again.

The Times’ Friday business columnist, Floyd Norris, just happened to have a piece in the paper (yes, I still subscribe to print) that day on MBIA’s lawsuit against Merrill Lynch. The fallen investment bank was a big client of MBIA during the go-go days before the mortgage bubble bust, when it paid the financial insurer to take the hit if any of its mortgage-backed securitisations should ever go sour (so-called credit default swap contracts).

MBIA wrote $5.7 billion worth of these for Merrill at extremely low fees of .08% annually, according to their complaint – all based on assurances from Merrill and credit ratings from Moody’s and S&P that the securities it was insuring were indeed the “highly conservative super-senior,” “above AAA credit quality” debt instruments they thought they were. No credit analysis whatsoever by MBIA of the securities’ underlying assets. In other words, as Norris indicates, it’s another “I didn’t do my homework” lawsuit that’s bound to become a chapter in someone’s book on how the whole financial meltdown started in the first place.

Grebeck got a chuckle out of the story since it wasn’t anything new to him. It was two years ago this month that he, hedge fund managers Bill Ackman and James Chanos and Yale Law School’s Jonathan Macey held panel during which they warned that financial guarantors like MBIA were increasingly dependent on credit rating agencies for their AAA franchises and weren’t doing enough of the homework themselves to make sure guarantees they were making would have the payout rates they expected.

The result was one giant, systemic fallacy of equivocation, where one term with two different meanings is used in a single argument. The argument was: these are AAA-rated securities, so they must be safe. How safe? Well, they wouldn’t be rated AAA if they weren’t as safe as other banks or corporate that earn the same rating, so they must be of the same credit quality – even though they weren’t. As Grebeck points out, in corporate credit there is recourse to secondary sources of capital, such as the value of buildings and capital stock, which can be monetised in case a company becomes insolvent. In structured credit, all you’ve got are the incoming cashflows from the underlying assets: once the cashflows dry up, you’re left with nothing else.

So why equivocate? Part of it was undoubtedly because the regulators let the financiers do it. Take a look at the pre-credit crisis version of the Basel II accord, an international treaty which governs, among other things, how much capital banks must keep on their books against certain types of credit risks. Sure, there’s a special section in Basel on so-called “synthetic” AAA-rated securities resulting from structured finance and how their capital charges should be calculated differently from corporate securities. But not differently enough: “the capital treatment of a securitisation exposure,” Basel said, “must be determined on the basis of its economic substance rather than its legal form.” As the MBIA lawsuit demonstrates, economic substance was hardly considered. So no wonder that banks were able to give their synthetic AAA claims the same risk weighing (20%) as allowed for corporate under Basel.

On the face of it, of course, they should have known better. Even without relying on Merrill, MBIA probably knew that ratings have a way of being off – just by their very nature. As Dimitris Chorafas explains in Economic Capital Allocation With Basel II, the step-ladder AAA, AA, A etc. gradations of credit rating agencies are hardly black-and-white distinctions. Instead, they come in what Chorafas calls “fuzzy sets” where a company rated AAA has a high possibility of being of that grade, but also a low possibility of being AA+, or one notch below, and so on. So even if MBIA took Merrill’s word as gospel, they sure didn’t allocate enough capital to the lower-probability outcomes. Result: under-priced services and over-exposure to risk.

But enough with the causes; what of the solutions? The sad truth is that they’ve been slow to come. It’s just this past July that the Bank of International Settlements, which oversees Basel, took steps to strengthen its so-called “three pillars” of governance. Chief among them are proposals to strengthen capital requirements for securitisations – i.e. end the fallacy of equivocation that allowed all the above-detailed financial arbitrage in the first place.

Will it work? Only time will tell. But for now, I’m tempted to side with Grebeck when he says that credit risk is about behavior – not models. It’s about time bankers were required to draw a hard line between the two.