Now that the financial regulatory reform bills are progressing in both houses of Congress, it means that to really be on top of things, you not only have to read the bills, you have to read the amendments. One example is the Miller-Moore amendment (full text here), which passed the committee 34-32, only to run into criticism from Andrew Ross Sorkin and Yves Smith, among others, as well as defenses by Felix Salmon.

The amendment applies to cases where (a) a systemically important (TBTF) financial institution is taken over by the government and (b) the government has to take a loss on the transaction (that is, the assets cannot be liquidated for enough to cover the secured creditors and the insured depositors). In those cases, it says that the receiver can choose to treat up to 20% of a secured debt as unsecured. (A mortgage is an example of secured debt; if you can’t pay off your mortgage, the bank gets the house instead. For financial institutions, we are largely talking about repos — transactions where Bank A sells securities to Bank B and promises to buy them back later, which is effectively a secured loan from Bank B to Bank A — and collateral held provided by Bank A to Bank B when derivatives trades move against Bank A.)

Why? One reason is to recover some money for the taxpayer. In the last round of bailouts, the imperative of keeping creditors whole meant that gaps had to be filled by taxpayer money. But there are two forward-looking reasons as well. One cited by Representative Brad Miller himself (in a comment on Smith’s first post) is to deter counterparties from seizing more and more collateral in the last days of a financial institution’s death spiral. A related reason that Salmon discusses is to generally deter financial institutions from relying on repos for their funding needs, since repo funding can evaporate overnight; that’s part of what killed Bear Stearns and Lehman Brothers last year.

The concern that some people have, including Smith, is that the fear of a 20% haircut will cause repo funding to dry up sooner and faster than it otherwise would, possibly making banks more susceptible to runs. Miller addressed this fear in another comment. His first point is that the amendment might not even apply to repos, since repos are (on paper at least) sales with an agreement to repurchase, not debt. Even if it does apply, he argues that the amendment will only kick in “even after all shareholders, bondholders and general unsecured creditors lose everything.” The language of the amendment is “amounts realized from the resolution are insufficient to satisfy completely any amounts owed to the United  States or to the Fund.” Since secured creditors’ claims can only be reduced after unsecured debt and uninsured deposits are written down to zero, it seems like we could only get to this point if a bank (a) were overwhelmingly funded by repos to begin with or (b) pledged all of its assets as collateral in a desperate attempt to raise cash right at the end. Furthermore, Miller says the haircuts would be discretionary, meaning that the receiver could choose not to impose them on creditors who had secured debt long before the crash (say, old-fashioned commercial mortgages).

I’m going to stop here, but I would like to give props to Miller for not only reading the blogs but bothering to weigh in on them multiple times. It makes you feel like we actually live in a participatory democracy.

By James Kwak

23 thoughts on “Details

  1. In all of there resolution all cases there is a tension between government efforts to protect the system (forestall runs) and a desire to protect the taxpayer. IN policy design, the tougher you get on the moral hazard front the less you will be able to mitigate systemc risk in a resolution.

  2. Doesn’t matter. This sucker’s going down regardless of how much ink is spilled and breath is wasted. It’s bred in the bone, baked in the cake, a done deal, a foregone conclusion. This is a demised parrot. It is *not* pining for the fjords.

    Look away from the internal convulsions. Who is writing the new international rules? What do they augur?

  3. This amendment is a good start. Add to it the elimination of the provisions under Bankruptcy Code Reform Act that allowed derivative holders and other creditors to legally seize assets prior to the filing. This in effect changed the priority and preference system that existed in the code. Thus, increasing the likelihood of risky behavior.

    Currently, there are far too many laws protecting certain debt holders over others. The taxpayers SHOULD NOT be liable for these debts. Banks need to understand that their foolish investments, loans, etc. will not be protected. Hopefully, this will deter others from making likewise foolish investment in Banks.

    Next we must have a very highly regulated system of all market transactions including derivatives and taxation of the transactions. Most of us pay a state sales or excise tax on our transactions. There is no reason to treat Wall Street differently. Their TALENT is not special, as witnessed by the mess they have made which had the sole purpose of lining their pockets with gobs of lightly taxed cash.

  4. This might be a little off topic, but as long as we’re talking about ammendments to financial reform measures Mike Konczal over at Rortybomb recently wrote about Representative Stephen Lynch’s (D. Mass) ammendment requiring OTC derrivites be traded on an open exchange. If the ammendment can make it into the final bill this seems to me to be a pretty important victory. Mr. Konczal, at least seems impressed. If you agree call and write your representatives to make sure the ammendment stays in the final bill.

  5. Slight correction; H.R. 3795, the “Over-the-Counter Derivatives Markets Act of 2009,” is the act requiring OTC Derivates be traded on open exchanges. Ammendment number 7 is Representative Lynch’s ammendment, and it requires that no individual firm can own more than 20% of the exchanges. This is to ensure competition on the exchanges. Or at least that’s how I read the language, but I’m certainly no expert. You can read the whole text of the ammendment here:

    Click to access lynch_035.pdf

    Mr. Konczal discusses it more detail in the post I linked above.

  6. This is a AAA post by James Kwak (by the way my triple AAA ratings are much more genuine and reliable than Moody’s). Representative Brad Miller’s amendment shows he is on the correct side of the issue. Kudos to Brad Miller. The number on Representative Stephen Lynch’s amendment should be more like 10%, but a 20% limit is better than nothing.

    This is why blogs like “Baselinescenario”, “Naked capitalism”, “Rortybomb”, “Econbrowser”, etc. are so vital right now. They are covering issues which only a few newspapers now bother to give a skim read on.

    We are counting on guys like Mike Konczal, James Kwak, and Bloomberg journalists to keep us informed on the DRAFT LEGISLATION. We don’t want to know about the watered down law after it’s passed. We want to know the DETAILS OF THE DRAFT LEGISLATION AS IT IS HAPPENING.

    And anybody like Chris Dodd or Barney Frank reading this, we are watching you, we can read, we know about those quiet moments when you meet with lobbyists, AND THERE WILL BE REPERCUSSIONS AT THE VOTING BOOTH ON THE GLAD-HANDING YOU DO WITH BANK LOBBYISTS.

  7. This is a really informative post by James Kwak. If the secured debt amendment survives just why would any firm go into Repos unless the sale is a legally settled absolute transaction and the securities may be taken at will until the the securities are legally repurchased?

    I was involved in the Treasury function of my firm. My views were sought out about investment policy. What will happen is that the scheduling of money flows will become ever more tight to enable the funds to be put into T Bills with demand deposits spread out to avoid risk. I assume here that contractual risk avoidance via credit default contracts covering very close need funds do not spring up. If such contracts did come into existence very short term rates would need to increase to cover the premium cost.

    The effect would be to build in risk avoidance rigidity even more than what has happened in the past. Then, why even put the money in a bank instrument. I am sure there will be shadow banking devices created to get around these kinds of amendments.

    If the US Government gets in the act, they get in at risk in the real world. The USG is trying to do exactly what the financial system itself did using swaps. Avoid risk. Be a big shot for free.

  8. Prudent lenders will make credit decisions based on worse case scenarios in the event of insolvency. It is doubtful that prudent lenders would lend to any but the strongest banks if the Miller Amendment were to pass. Or if they did lend to less than the strongest, they would charge substantial upfront fees to offset potential losses down the road.

    Eliminating the special treatment accorded CDS and making sure bankruptcy preferential transfer and fraudulent conveyance laws are applicable in bank insolvencies would be a clean and straightforward way of eliminating collateral grabs that push a bank of other financial institution into insolvency.

  9. I still strongly believe credit default swaps should be ABSOLUTELY ILLEGAL. But obviously the law making them illegal isn’t going to happen anytime soon. So at least let’s put them on exchanges. Exchanges will do VERY little to control the risk, but at least if they were required to be put on an exchange we could have a better gauge of the AMOUNT of derivatives/credit default swap trading.

    Again the best of all worlds would be to make credit default swaps illegal, but then we wouldn’t have the fun of learning the same lesson redundantly would we??? Then guys like Barney Frank couldn’t slobber all over themselves talking to bank lobbyists.

  10. A CDS is like a life insurance policy on a company. In real life insurance you are required to have an insurable interest to be able to buy life insurance on someone, and the rules on what is an insurable interest are very tight, generally a spouse will qualify, and maybe a business partner, but that is about it. With CDS’s there is no such requirement, sort of like a cardiac surgeon could take out a policy on the patient he is about to cut into (just to make sure that the bill would be paid in case any thing went wrong, you know). Require an insurable interest for a CDS, iw you have to own the bond, and can not have CDS’s in excess of the value of the bond.

  11. That’s a dead issue. I’ve said many times I think Alan Blinder is the best choice. It’s a moot point at this stage.

  12. By the way, am I the only person who thinks Andrew Ross Sorkin is way to cozy with bankers/Wall Street??? I watched Sorkin describe the crisis on television and the guy had this shit-eating grin on his face like it was his birthday or something. He reminds me of a politician that has no idea how these things he writes about affect everyday people.

    People are losing their homes, this isn’t a game of poker in the den of your house Mr. Sorkin.

  13. Even if CDS’s remain legal, which I agree they should not, we at least can pass a law requiring that they, as with all other forms of (regulated) insurance, must be adequately reserved, so that when and if they must be honored the cash will be readily available to cover exposures. They reserve requirements also must be high, because, as we have seen, when some go bad, many go bad quickly following. The main issue as I see it, is that they are bought to cover what are generally very severe risks, except in cases where they are done as a part of policy to cover all bad financial bets.

  14. Word Ted K. This site, and others Naked Capitalism, The Economist View, Zero Hedge, Calculated Risk, and others mentioned above provide a heroic service to us unwashed voiceless masses by detailing and articulating on language we can all understand the sordid inner workings of the predatorclass and the finance oligarchs. And what a woefull study it is. Personally, I am far beyond demands for replacing Bernake and Geithner and Summers, – I want these Goldman Sach minions and parrots sent to jail, or preferrably worse. That said, – far toofew are benefiting from the suffering, and off the backs of far toomany at the governments (both the fiends and shaitans in the bushgov, and the Obama government.)

    The predatorclass has been afforded extraordinary government largess and favortism in the last year intensely of over the last decades specifically. It is way past time for someone in a position of leadership to standup and truly give voice to the voiceless and place the best interests of the American people where it should be, above and beyond the best interests of the predatorclass and the finance oligarchs.

    Cudo’s to Citi for hiring Willem Buiter, hopefully the shape of things to come.

  15. Forgive the double post, – but I meant to say: {“That said, – far toofew are benefiting from the suffering, and off the backs of far toomany at the governments (both the fiends and shaitans in the bushgov, and the Obama governments) behest”}

  16. The problem with regulatory reform legislation to date, including the Miller-Moore amendment, is the reliance on regulators. I worked at the SEC for 27 years and if I learned anything, it is that you cannot rely on regulators. They are too subject to politics and ideology as political appointees who hire, fire, force out career employees and front line regulators (some of whom understand their role and the importance of regulation). In addition, there is political influence that results from the fact that Congress controls the purse and the so-called regulated control Congress. Try to establish rules governing the independence of auditors or accounting rules banning off-books accounting, for example, and Congress will come down on the regulaors like a ton of bricks. No, we cannot rely on the good faith of regulators and we cannot vest them with broad discretion.

    Meaningful reform requires restructuring the financial industry to prevent conflicts of interest to the extent possible, and full disclosure where it is not possible. Players must be required to have their own fortunes at risk if we expect them to measure risk and act prudently. Regulators must be provided with tough legal standards and with suffient authority to take appropriate enfocement action, when necessary. The parameters of regulatory (as distinguished from prosecutorial) discretion need to limited and clearly defined.

    Let’s face it, human enterprises get in the most trouble when they rely too much on human nature and the flavor of the day. The trick to regulation is to find the structures that minimize conflicts of interest and risks to the system and require those who take risks to bear the consequences, good and bad, of their actions. To rely on the good faith judgements of regulators, in a system where the regulated control the finances that influence to exercise of power, is pure folly.

  17. Financial elites until relatively recently carried massive personal risk. Investment banks were only acceptable to investors if they were the traditional general partnership. It was an axiom of public accounting that they put their fortunes at risk as a general partnership for expressing their professional opinion about financial statements. Similarly for law firms. The really well heeled did their banking with private banks that were general partnerships.

    That all changed in the late seventies.

    Even banks before the essentially unrestricted use of the Bank Holding Company put the capital of bank shares at risk. The bank could be seized by the banking regulators . The stockholder’s lost their investment. That much is still in place.

    Limited liability of principle’s underlies the problem of no fear in finance because the principle’s are employees and not general partner’s .

    J Pierpont or Jack Morgan had their entire fortune on line. They were principles at risk not fancy employee’s.

    The bonus would be moronic to the partner since they allocated partnership profits in ways that accomplished what bonuses did. Basing the bonus plan on a percentage of revenues is what bureaucrats concoct . Something that general partners never would do since they divide up only profits. The partners had to make good losses with capital calls. If a firm went down it was usually when capital calls on partners were beyond their capacity.

    The big shots of big finance think and act like the employees they are. This nasty problem cropped up almost immediately in the years after conversion of big finance to limited liability status.

    This same observation goes for hedge funds as we know them too. Syndicates involving the really wealthy in the past also had general partners with substantial investment and unlimited risk.

    There was also the implied responsibility of underwriters to watch over their bond issuances. The investment banks required a board presence and it was a powerful presence too.

    Put back risk of entire fortune along with better regulation and we might go a long way to solving the problem. But this goes entirely against the idea of public ownership. The idea of the public corporation as a vehicle for speculation is now far too pervasive to do much about it other than restore assessable shares of stock. That seems impossible now.

    What has happened was really quite predictable. It was certainly discussed quite often in business classes in the fifties and before.

    If the bank goes bust, the principles lose all built the financial structure. The present structure destroyed the edifice in 30 years.

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