Aligning banks' shareholder, management, and public interests.

Perhaps the only way to 'square the circle' and align the competing and, lately, contradicting interests of shareholders, management, depositors, and especially the depositors' guarantors (the federal govt: FDIC & Fed), is to go "back to the future". Back to the old merchant banking partnership model of the 19th and early 20th century. Think about it: how many scandals have involved Brown Brothers Harriman? None. Precisely. They are what used to be.

The old partnership model gave management unlimited personal liability as each partner was a general partner. (Obviously we'll need meaningful tort reform before this model can work again -- don't hold your breath!) Upon retirement partners "went limited" -- i.e., they became limited partners with limited liability and a limited voice in managing the firm. In some cases, or in addition (I'm unsure on this) their partnership or equity interest converted to subordinated debt, giving them regular, contractual income and making them senior creditors ahead of the managing (general) partners but junior to other creditors and depositors. In the partnership model, as Chuck Colson put it, "If you have them by the balls, their 'hearts & minds' will follow".

The bad news for mgmt was there was bonuses were small(-er) but the good news was they could build real, true wealth over time. But, they could lose it all with one big, stupid move by any partner. Like subprime, for example. It made them attentive. As Mark Twain once said, "Put all your eggs in one basket. Then watch it very, very carefully."

Ten years ago I forecast -- erroneously or maybe only prematurely -- that the private equity ("PE") funds and hedge funds would converge. They did, but in only very limited fashion by poaching eachother's turf and not, as I'd expected, by merging/converging. Private equity is the closest equivalent we have today to the old "merchant banks" of the Rothschilds and Morgans of previous centuries.

The investment banks of the late 20th century were gutted by the bigger balance sheets of the commercial banks on the one hand and the smarter balance sheets of the hedge funds (and PE firms) on the other. Beginning with LTCM and persisting up to & through 2007, there's been a huge "brain drain" from I-banks to hedge funds ("HF"). But if you combine the two models, then you have the old merchant banking model -- e.g., wherein a John Pierpoint Morgan would commit his (he & his partners') capital to a deal, be it M&A or loan or etc. A model that was viable for centuries (Venice, London, New York). PE & HF are today's analogs to investment banking and trading. But Mr. Morgan's depositors didn't need insurance: they had his balls as collateral.

The advantage to combining PE &HF firms is continuity, and the ability of the founders to "go limited" (monetize what they've built) without selling the firm, w/o placing it in strangers' hands. It also creates permanent capital: no more lining up endless rounds of limited partners for the monotonous dogs' breakfast of Roman numeral funds (I, II, III, IV, etc.). It creates a permanent capital structure. Depositors provide the leverage, but it's on-balance sheet and the general & ltd partners stand as surety, to their last penny.

Epilogue: When I started in banking, back in the 1970's, if a bank exceeded it's legal lending limit to a client (10% of capital), then the bank's directors were each personally liable for the full amount of the loan until repaid, not just the excess. Needless to say, no one ever exceeded their legal limit! (Except crooks like Jimmy Carter's buddy and budget director Burt Lance.) "Value at Risk" is a useful exercise and data-point but whose value is at risk is more definitive!

JRB

2/17/09

Michael Phelps vs. Bill Clinton

While Phelps' dope-smoking is something less than we expect from our Olympians, he didn't stone-wall or lie about it. Instead, he recognized his mistake, "manned-up" with an apology, and did not whine about his suspension. He could have done what is considered perfectly respectable, then & now, by our ruling class and said, "I didn't inhale." Phelps is so naive, he probably pays his taxes!

JRB

2/7/09

WSJ: "A Republican Fannie Mae"

The 4% or 4.5% "solution" (to refinance every mortgage in America at 4% or 4.5%) is a stupid suggestion for many reasons, as the WSJ noted. One reason is: Think of the logistics. City & county recorders will be buried under millions of mortgage submissions. In many jurisdictions you need a lawyer to prepare the documents; they'll be swamped by their windfall. Every second lien (HELOC) must also be refinanced (by whom?) or they slide into first place. Will new title policies be issued and new appraisals be prepared? And who will pay NYC & NYS's extortionate mortgage taxes & fees? Will mortgages with 5, 10, or 15 years be refinanced to 30 years or will they too have 4% coupons, and thus must trade at a sizable premium to par. $10 trillion of mortgages and MBS will disappear from bank, insurance, and mutual fund balance sheets creating hundreds of billions in unexpected gains & losses and requiring massive and immediate reinvestment.

There is a simple and sane way to accomplish a similar subsidy (which I've blogged before). Mortgage interest could be made 100% deductible -- essentially a tax credit not just a deduction. The incremental logistics are nil, just file your IRS Form 1040. It's fair, proportionate, and easy. If you don't pay your mortgage you don't get the deduction, so one 'moral hazard' found in all the other proposals is eliminated. The credit could (should) phase out after five years, to avoid long-term distortion of housing markets.

JRB

2/7/09

"Toxic" asset solutions: a Fed' collared guaranty

"Toxic Assets" -- Writing in the CFA Institute's Financial Analysts'Journal Harry Markowitz (Nobel Prize, economics, 1990) suggests the feds undertake a detailed fundamental valuation of structured securities. (Something I've been doing in a related context for the past year.) My suggestion for the Fed follows. (I forgot that I wrote about this 2 days ago. The Markowitz article inspired me again. Maybe I'm getting senile, but at least my thinking is consistent even if my memory is not!)

If, for once, the feds want to be parsimonious instead of profligate with their (our) limited resources I'd suggest they structure the "toxic asset guarantees" as a collared financial guaranty insurance policy, or cashflow-CDS contract. "Collared" in that the Fed pays on the downside but receives the upside on insured ABS, RMBS, CDO, et al. The strike-prices (cashflow thresholds) would be based on some combination of the fundamental evaluation mentioned above and negotiation between the Fed and the bondholder.

For example, the bondholder picks the downside protection (lower strike) and the Fed picks the upside strike, either a zero-premium collar strike or with a premium. The guaranty maturities could be negotiated, or limited -- i.e., Fed limits itself to 5 or 10 year wraps, long enough for markets to adapt).

Importantly, for both transparency and so the Fed doesn't misprice, anyone else may place a bid with the Fed against the current bondholder, buying both the bond and the Fed wrap. Or vice-versa: they can bid to be the wrap provider (which would have to be a collateralized CDS). The Fed would compile periodic bid lists, multiple securities from multiple holders so the holders would not be revealed. The current holder could set an auction 'reserve' price (i.e., no forced "fire-sale" loss). Like normal insured bonds, Fed wrapped bonds receive a new CUSIP.

The Fed's risk on this would be systemic -- a risk it already has, but at least here they'd get paid for it! They'd be taking their own (federal govt) 'moral hazard' on mortgage modifications, too. The Fed would pay claims over time; not ballooning its balance sheet as it has so unnecessarily done (e.g., CP bailout, discussed elsewhere).

Transparency, rationality, liquidity for both the private & public sectors,supply & demand, market-clearing prices, existing contract rights respect not abrogated, parsimonious of both fiscal & monetary policy, ... all the good stuff!

Complex and labor intensive but, as Markowitz said of his (or our) idea, if they'd done it (fundamental valuations) back in 2007 they'd be finished by now instead of still wrestling with the same damn problem a year later!

JRB

2/4/09

Daschle, Rangel, & Geithner vs. Bank CEOs

Daschle, Rangel, Geithner ... no wonder Democrats don't mind raising our taxes. They don't have to pay them! Say what you want about bank CEOs, they do pay their taxes! (Lots & lots of taxes. Just look at the impact on NYC & NYS's budgets with the drop in Wall Street bonuses!)

JRB

2/3/09

Fed follies: a more intelligent CP program

Updates in the news about the Fed's bulging commercial paper portfolio inspired an expansion of my earlier post about how the Fed could done this much more efficiently.

To illustrate how simple this could have been, think about bankers acceptances ("BA"). When a bank guarantees or "accepts" a trade-bill or letter of credit it stamps its acceptance on the bill or L/C. (I'm speaking of a paper-based world.) BAs are negotiable and desirable (as two-name paper) money market instruments. If the Fed similarly stamped its acceptance on CP they too become negotiable instruments. In fact, they become a form of currency! (Look at those bills in your wallet: they're no more than the Fed's promise to pay.)

This is money that does not show up on their balance sheet as it's only a contingent liability. I'm not sure what kind of "M" it would be (e.g., M3, monetary base), but it doesn't "crowd out" the normal functioning of financial markets.

JRB

2/3/09

Fed Follies: TARP - How it should work

Dugan Says Pricing Assets ‘Key’ Issue in Bank Rescue

2009-02-02 16:55 - By Margaret Chadbourn and Alison Vekshin

Robert Rubin Says ‘Mark-to-Market’ Accounting has Done ‘Damage’

2009-01-28 18:14 - By Josh Fineman and Ian Katz

Price and value are two different things -- three if you include mark-to-market (MTM). (See below) If regulators were able to validate fair or economic values, then maybe prices wouldn't be so depressed and they wouldn't need to buy so much. Price is relevant for leveraged institutions like banks & brokers but, ultimately, if value -- fair value or economic value -- is perceived then maybe they can fund themselves. (FASB has corrupted the term "fair value".) In buying assets the Fed 'gives up some of their height', as Teddy Atlas might say (ESPN-2's boxing analyst), and as I've said before.

Here's the sketch of an idea how the Fed could be more parsimonious with their capital -- our tax dollars! First, regulators validate fundamental or fair values (not the corrupted FASB definition) by modeling the expected cashflows. Then they validate market value (FASB's fair values, levels 1 - 3) and translate or 'calibrate' that value/price into the implied cashflows. The Fed then puts a guaranty 'collar' on those cashflows: the Fed pays the shortfall if actual cashflows are less than the market-implied, and the Fed receives the excess if cashflows are greater than the fundamental forecast. As with conventional bond insurance, the bonds receive a new CUSIP and trade as one with the Fed's wrap. Perhaps it could be a derivative that could trade separately (although forever tied to the original bond's performance). Obviously, this is a massive undertaking given the number of banks, securities, and their complexities. But things like this have been done before and so can be done again. Sometimes there is no shortcut.

Example of price v. value v. MTM: The negative basis trade -- if I bought an investment grade bond at T+200 and matching CDS protection at T+75 then I've locked-in a 125 bps p.a. return. When spreads blew-out, let's say doubled to T+400 & T+150, respectively, then I've a larger MTM loss on my bond than gain on my CDS so I report a huge MTM loss. But, assuming my CDS ctpy is now the Federal Reserve (d/b/a BofA or JPM) and not Lehman, I still have a locked-in 125 bps pa return which has gone up, not down, in value because the discount rate is now lower! (ceteris paribus -- legal risk, etc.)

JRB

2/2/09