A proposal to prevent wholesale financial failure by Lasse H. Pedersen and Nouriel Roubini

The worst financial crisis since the Great Depression has highlighted the risks from the collapse of systemically important financial institutions. Huge bail-outs were undertaken based on a fear that the collapse of such institutions would cause havoc, with collateral damage to the real economy. Examples include Bear Stearns, Fannie, Freddie, AIG, Citi¬group, the insurance of money market funds and new US Federal Reserve programmes for banks and broker-dealers. Allowing Lehman Brothers to collapse had such severe systemic effects that the global financial system went into cardiac arrest and is still dealing with the aftermath.

We propose a way to measure and limit this systemic risk and reduce the moral hazard and the cost of bail-outs. Our proposal is to impose a new systemic capital requirement and systemic insurance programme.

The current situation leaves the system vulnerable to financial contagion when big banks (or many small ones) go bust. The root of the problem is that banks have little incentive to take into account the costs they impose on the wider economy if their failure prompts a systemic liquidity spiral. This is akin to when a company pollutes as part of its production without incurring the full costs of this pollution. To prevent this, pollution is regulated and taxed.

Unfortunately bank regulation, such as the Basel accord, ignores systemic risk since it analyses the risk of failure of each bank in isolation. It seeks to limit the probability of failure by each bank, treating isolated failures and systemic ones in the same way (and also ignoring how much a bank loses if it fails). However the move by many large banks to lever their balance sheets with similar mortgage-backed securities is more dangerous than if they had made loans to diverse borrowers.

More broadly, a systemic crisis that feeds on itself is more dangerous than the isolated failure of smaller banks. A small bank will probably be taken over with a smooth transition of operations – it does not bring down the economy.

There are two challenges associated with reducing the risk of a liquidity crisis. Systemic risk must be first measured and then managed. We propose to define a bank’s systemic risk as the extent to which it is likely to contribute to a general financial crisis. This measure can be estimated using standard risk-management techniques already used inside banks – but not across banks, as we propose – to weigh how much each trading desk or division contributes to the overall risk of a bank. We set this out in an NYU Stern project on restoring financial stability.

With this measure of systemic risk in hand, a regulator can manage it. We propose two ways to manage systemic risk. First, the regulator would assess each bank’s systemic risk. The higher it is, the more capital the bank should hold. This would seek to ensure that the banking system as a whole had sufficient capital relative to the system-wide risk. This is just like the headquarters of a bank charging each trading desk or division for use of economic capital measured by its contribution to overall firm risk.

Second, each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector. This would provide incentives for a bank to limit systemic risk (to lower its insurance premium), provide a market-based estimate of the risk (the cost of insurance), and reduce the fiscal costs and the moral hazard of government bail-outs (because the company does not get the insurance pay-off). Since the private sector may not be able to put aside enough capital for all the systemic risk insurance, government could provide part of it. Government already provides such partnership on insurance with the private sector in terrorism insurance.

We believe our proposal offers several advantages by explicitly addressing systemic risk based on tools already in use by private companies to manage internal risks. Our proposal is a better way to deal with the trade-off between letting a large institution go bust (Lehman, for example) and causing a global cardiac arrest of the financial system or being forced to spend trillions of dollars of taxpayers’ money to bail out such systemically critical institutions.

Lasse H. Pedersen and Nouriel Roubini are professors at NYU Stern School of Business and the proposed regulation of systemic risk is part of the NYU Stern project "Restoring Financial Stability: How to Repair a Failed System" (John Wiley & Sons, 2009)

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Restoring Financial Stability by Viral V Acharya and Matthew Richardson

There are many cracks in the financial system, some of which we now know, others no doubt we will discover down the road. The eighteen white papers and executive summaries of each chapter of New York University Stern School of Business book, “Restoring Financial Stability: How to Repair a Failed System”, forthcoming this March by John Wiley & Sons, and contributed to by 33 of our faculty members, describe a relevant issue at hand and corresponding regulatory proposals. A common theme of our proposals notes that fixing all the cracks will shore up the financial house but at great cost. Instead, by fixing a few major ones, the foundation can be stabilized, the financial structure rebuilt, and innovation and markets can once again flourish.

This short note is meant to encapsulate the key themes from the book, focused on the causes of the financial crisis of 2007-2009 and regulatory principles that we recommend drive the longer-term reforms.

Causes

Yes, there was a housing bubble and a crash…

There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble. There are many statistics to back this up. For example, in the five year period from 2002-2007, the ratio of debt to national income went up 100% from 3.75 to 4.75 to one. It had taken the prior full decade to accomplish this feat, and fifteen years prior to that. During this same period, house prices grew at an unprecedented rate of 11% per year.

When the “bubble” burst, it necessitated a severe economic crisis to come. The median family, whose house represented 35% of all their wealth and who was highly levered, would not be able to continue as is. The economy was going to feel the brunt of it.

It is much less clear, however, why this combination of events led to such a severe financial crisis, that is, why we had widespread failures of financial institutions and the freezing up of capital markets. The systemic crisis that ensued reduced the supply of capital to creditworthy institutions and individuals, amplifying the effects to the real economy.

There is no shortage of proximate causes. Mortgages granted to people with little ability to pay them back and designed to systemically default or refinance in just a few years, depending on the path of house prices. The securitization process that allowed credit markets to grow so rapidly but at the cost of lenders having little “skin-in-the” game. Opaque structured products that were rubber stamped AAA by the rating agencies more interested in fees than risk assessment.

But wasn’t the risk transferred through credit derivatives?

Somewhat surprisingly, this is not the ultimate reason the financial system collapsed. If this were it, then capital markets would have absorbed the losses, and the financial system would have moved forward. Instead, blame needs to be squarely placed at the large, complex financial institutions (LCFIs) -- the universal banks, investment banks, insurance companies, and (in rare cases) even hedge funds -- that dominate the financial industry.

The biggest fault lies in the fact that the LCFIs ignored their own business model of securitization and chose not to transfer the credit risk to other investors.

The whole purpose of securitization is to lay risks off the economic balance-sheet of financial institutions. But the way securitization was achieved, especially during 2003-2Q 2007, was more for arbitraging regulation than for sharing risks with markets. The reason why banks face capital requirements is that they have incentives to take on excessive risks given their high leverage. Capital requirement ensures that first, banks find it costly to take on risks, and second, when they get hit by a shock, there is enough of a buffer zone to protect them.

But that's not what happened. Banks set up a shadow banking sector of SIV’s and conduits funded by asset-backed commercial paper that was guaranteed – often fully – by banks through liquidity and credit enhancements. Designing things this way allowed banks to transform on-balance sheet loans and assets into off-balance sheet contingent liabilities, and thereby exploit loopholes in regulators "Basel" capital requirements. Measures of risk barely moved even as their balance sheets exploded with liquidity “puts” (sold to the shadow banking sector) and AAA-asset backed tranches. These risky assets were systemic in nature as they were in effect equivalent to writing out-of-the-money put options on aggregate crises.

This lack of risk transfer – the leverage “game” that banks played – is the ultimate reason for collapse of the financial system, in our opinion.

Bankers and regulators are both to blame…

It is important to acknowledge that in the period leading up to the crisis, bankers and insurers increasingly paid themselves through short-term cash bonuses based on volume and marked-to-market profits, rather than on long-term profitability of positions created. There was neither any discounting for liquidity risk of asset-backed securities, nor any proper assessment of true skills of large “profit”-centers. All this just served to make regulatory arbitrage the primary business of the financial sector.

Thus, the current regulatory architecture cannot escape blame either. In fact, its cracks made the system vulnerable to bankers’ errors and short-term incentives in the first place. In a world without regulation, creditors of financial institutions (depositors, uninsured bondholders, etc.) would put a stop to excesses of risk and leverage by charging higher costs of funding, but lack of proper pricing of deposit insurance and too-big-to-fail guarantees has distorted incentives in the financial system. And, for years, regulation – capital requirement in particular – has targeted individual bank risk, when the justification for its existence resides primarily in managing systemic risk. It is to be expected that financial institutions would maximize returns from the explicit and implicit guarantees by taking excessive aggregate risks, unless these are priced properly by regulators.

Regulatory principles

Where should the regulators start to fix the system? The integration of global financial markets has certainly delivered large welfare gains through improvements in static and dynamic efficiency - the allocation of real resources and the rate of economic growth. These achievements have however come at the cost of increased systemic fragility, evidenced by the ongoing crisis. The challenge of redesigning the regulatory overlay to make the global financial system more robust must be met without crippling its ability to innovate and spur economic growth.

Four changes seem paramount, each addressing either regulatory arbitrage or the externality imposed by actions of individual institutions on systemic stability. We argue in the book that future regulation should:

• Change the incentives of traders and large profit centers at large financial institutions with “bonus-malus” reserve accounts, which penalize employees whose actions trade current profit for future losses. This would essentially bring "clawbacks" into the compensation system. UBS's bonus scheme, granting bonuses in the form of claims on a portfolio of toxic assets, is a good example.

• Prevent obvious regulatory arbitrage (privatizing, for example, the financial investments of government-sponsored enterprises) and charge for guarantees – deposit insurance, too big to fail, loan guarantees and the bailout – using marking-to-market that reflects leverage and risk in a continual manner. It will be good to know whether the financial system can even pay for the subsidies it receives.

• Recognize the negative externality of LCFIs. Then quantify the systemic risk of LCFIs and “tax” (through capital requirements or deposit insurance fees) their contributions to systemic risk rather than individual risk. This is hard to do, but present regulations do not even claim to address the problem. The need for such systemic risk regulation, possibly by augmenting Central Bank agendas, is only underscored by the growing size of the few remaining players in the financial arena.

• Enforce greater transparency of over-the-counter derivatives positions and off-balance-sheet transactions, employing centralized clearing for standardized products and, at a minimum, centralized registries for customized ones so that counterparty risk can be assessed.

Some say that these changes inhibit financial innovation. We think this gets the issue wrong. The goal is not to have the most advanced financial system, but a financial system that is reasonably advanced but robust. That's no different from what we seek in other areas of human activity. We don't use the most advanced aircraft to move millions of people around the world. We use reasonably advanced aircrafts whose designs have proved to be reliable. The same is the case with ethical drugs. Although we are now in a golden age of biomedical research, our goal is to sell only products that have been tested extensively.

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Expect Even More Shadow Banking Losses by Viral V Acharya and Philipp Schnabl

Off-balance sheet vehicles exacerbate the crisis... On January 19, the Royal Bank of Scotland (RBS) revealed a record-setting loss: its $41bn write-down was the largest loss in UK history. After debt guarantees of $25bn and a capital injection of $8bn last October, the UK Government is now discussing a second bailout or further nationalization of RBS. A day later in the U.S., money manager State Street Corp. lost 59% of its market cap after announcing a whopping loss of $10bn.

Eighteen months into the financial crisis, where are these losses coming from? Though the losses are new, the source of the losses is familiar: write downs on off-balance sheet vehicles. The shadow of the "shadow banking sector" continues to loom large.

Take the case of RBS. Its exposure to off-balance sheet vehicles comes primarily through its ill-timed takeover of ABN Amro in 2007. Before the financial crisis, ABN Amro was one of the world's largest sponsors of off-balance sheet vehicles with an exposure of more than $100bn. This business generated small margins in good times and allowed ABN Amro to expand its asset base, but exposed it to huge losses in bad times.

For example, in December 1999, ABN Amro set up an off-balance sheet vehicle called Amstel Funding Corporation. By December 2006, ABN Amro had acquired asset-backed securities worth $28bn via Amstel Funding Corporation. About 91% of assets were Collateralized Debt Obligations and the remainder residential mortgages. About 98% of assets were AAA-rated. However, there was little transparency on asset quality beyond ratings, and some assets were probably originated by ABN Amro itself.

So how could ABN Amro convince investors that it was worthwhile to put their money into Amstel Funding Corporation? ABN Amro had a simple and elegant solution: it issued short-term liabilities and offered investors an option to return the assets to ABN Amro. This was called "liquidity enhancement" and insured investors against any downside risk.

And the insurance policy paid off, but of course only for investors! Since the start of the crisis not a single investor in these ABN Amro off-balance sheet vehicles has lost any money. That's good news for investors in off-balance sheet vehicles, but bad news for RBS. Eventually, somebody had to take the losses on those vehicles, which RBS recognized on January 19. The story of State Street is not much different.

So, why did banks set up such off-balance sheet vehicles to begin with? Banks should have understood that off-balance sheet vehicles could put their entire business at risk.
Effectively, there were two reasons working together.

First, low interest rates, huge foreign capital inflows, and underpriced deposit insurance provided banks with cheap sources of funding.

Second, regulators required banks to hold significantly more equity against assets on its balance sheet than assets in off-balance sheet vehicles. Hence, banks had a big incentive to save on costly equity and circumvent capital requirements--which had been introduced precisely to offset such risk-taking behaviour--by putting assets into off-balance sheet vehicles. This would raise earnings and return on equity in good times, but, if things were to go wrong, the government would end up having to bail them out.

As losses from the shadow banking sector come to light, banks are plunging deeper into a crisis – a slow and painful demise that they themselves engineered.

Here’s the paradox. The off-balance sheet vehicles supposedly provided transfer of credit risk from bank balance-sheets. And yet they have been a primary cause of their demise. The fact is that there was little, if any, transfer of credit risk from banks to the economy. Put bluntly, the off-balance sheet vehicles were financial innovations designed to arbitrage regulation, allow banks to create excessive aggregate risk in the form of housing stock, and do so without holding enough capital against the risk.

So what does this view of the ongoing crisis tell us about things to come? Unfortunately, it casts a shadow of further gloom.

Banks are still running large off-balance sheet vehicles. In September 2008, off-balance sheet vehicles in Europe and the United States had outstanding short-term liabilities of $935bn. To put this into perspective, total assets in these off-balance sheets are more than twice as large as total assets in Structured Investment Vehicles (SIVs) before they went broke in the second half of 2007.

These remaining off-balance sheet vehicles are surviving to an extent only because the Federal Reserve has set up several liquidity facilities that keep them on life support. Even though this may be an appropriate fix in the short-run, it is hardly a long-run solution.

With no revival of the housing sector or the economy in sight, banks have to eventually come clean and reveal how much they lost on those vehicles. They have to tell the world that they did not transfer credit risk after all. And while the world digests further news of banking sector woes, the next round of bailouts will be just around the corner. Or perhaps the time has come to nationalize banks, set up a giant "bad bank" to be resolved over time, and give banking a fresh start. That may be the most important stimulus the economy needs.

Viral V. Acharya and Philipp Schnabl teach at New York University's Stern School of Business. Mr. Acharya is also affiliated with the London Business School. This piece is adapted from forthcoming book, "Restoring Financial Stability: How to Repair a Failed System", (http://whitepapers.stern.nyu.edu/home.html), edited by Mr. Acharya and Matthew Richardson, John Wiley & Sons, forthcoming (March 2009).

This article also appeared on Forbes.com, 3 February 2009:
http://www.forbes.com/2009/02/03/shadow-banking-rbs-opinions-contributors_0203_acharya_schnabl.html

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Good Bank, Bad Bank; Good Plan, Better Plan, by Max Holmes

There is a growing consensus that Washington has two options if it wants to end the credit freeze and restore confidence in our banking system. One is to, in effect, nationalize the major banks, which would be hugely expensive and would undermine our free-market system. The other is the “bad bank” solution, under which the government would print enormous amounts of money to buy all these banks’ “toxic” assets and to put them into a huge new financial institution that would operate under federal control and sell them off over time. This is a better idea than nationalization, but the proposals along these lines being bandied around Washington would all be prohibitively expensive and probably ignite inflation.


However, there is more than one way to pull off a “good bank/bad bank” rescue, and a look at two examples from the 1980s may help show a path forward.

In 1988, as a young analyst at the investment bank Drexel Burnham Lambert, I worked on two major “bad bank” transactions. In the first, the Federal Deposit Insurance Corporation seized First City National Bank of Houston. The government put up $1 billion to create a “bad bank” that took on First City’s bad energy and commercial real estate portfolios; it was able to liquidate those assets over the next 15 years, recouping much of the money it had invested in the bailout. And First City was quickly able to raise $500 million of private capital and get a new lease on life (although it faltered a few years later because of unrelated bad loans).

That success led to a second government-orchestrated rescue that year. The bad commercial real estate and home mortgage portfolios of Mellon Bank of Pittsburgh were transferred to a bad bank called Grant Street National. While the government oversaw the transaction, the money Grant Street used to buy Mellon’s troubled assets came from private investors looking for long-term profits. By 2005, Grant Street’s liquidation was also successfully completed, at a profit.

The two bailouts differed in details. But both succeeded because when all of the bad assets were removed from the troubled bank’s balance sheet, it was immediately able to raise new capital. This allowed management to focus on getting back to business without the distraction of dealing with underperforming loans. And the government and the outside investors who took up those loans could afford to be far more patient than the banks that held them.

The lessons for today? So far, the Treasury and the Federal Reserve have done a good job of consolidating the commercial and investment banking sector into four giants: Bank of America, Citigroup, JPMorgan Chase and Wells Fargo. But based on those banks’ continued depressed stock prices and the high cost of credit they are being forced to pay, it is clear that the market is not yet convinced of their health.

Instead of printing up money to create a huge, unwieldy “bad bank,” I would recommend creating separate bad banks for each of these four institutions (and perhaps some others), and financing them by having the government assume an amount of each good bank’s corporate debt equal to the value of the troubled assets put into the bad banks.

It would work this way: The managements of each of the four banks would be given a one-time opportunity to sell any assets (from vanilla domestic corporate bonds to the most exotic foreign derivatives) to a new bad bank owned entirely by the government. The only condition would be that the four big banks would have to convey the assets at year-end, audited book values, not at some guess of what they might be worth down the road.

While these assets are “toxic” to the banks right now because they are illiquid, volatile and at depressed prices, the government can hold on to them until they regain value, making it an investment for the taxpayer that could pay off handsomely in the end. The public would have transparency, as it would know what the assets are and how they are liquidated over time.

Most important, however, the government would pay for these troubled assets not by printing new cash, as under most current bad-bank proposals, but by taking on an equal dollar amount worth of each bank’s “liabilities” — that is, notes, bonds and other obligations that the bank owes to other lenders or investors.

The government, not the banks, would choose which liabilities it would take responsibility for. Presumably, federal officials would assume notes and bonds with maturities roughly in line with the real durations of the troubled assets they are taking off the banks’ hands, mainly 3 years to 10 years. This would allow the government to pay down these liabilities through the cash flow that will be generated from the troubled assets themselves. The bad banks would have a proper match between assets and liabilities, a critical ingredient for managing any investment pool.

The bad banks would then be able to work out their troubled assets over time rather than sell them in a fire sale — similar to the successful solution imposed on the savings and loans that were taken into the Resolution Trust Corporation in the 1990s. The government could hire professional money managers, working under an incentive-heavy compensation plan, to oversee the liquidation. (Disclosure: firms like mine might be potential candidates for such a job.) This would be far wiser than leaving it to government bureaucrats, who might simply seek to sell as many assets as quickly as possible and close the files.

The benefit to the good banks would be substantial: they would retain strong asset bases, they would no longer be burdened by toxic securities, and because they would be able to trust their fellow-banks’ balance sheets, they could safely extend credit to one another and to American businesses and households. With their equity capital remaining intact, they would easily meet domestic and international capital requirements.

The economy would benefit because the credit squeeze could finally end, as the good-bank employees could concentrate on lending rather than simply surviving. And because no new money would be printed, inflation would be much less of a concern.

Insurance companies, smaller banks, money-market funds and other institutions that are the primary holders of these banks’ intermediate-term liabilities would also receive an enormous benefit: in place of “weak” debt they now hold from troubled banks, they would have securities guaranteed by the Treasury.

There are two other issues. First, for the four major banks, the good bank/bad bank transactions should be mandatory; the industry will stabilize only if the four work in tandem. Second, the government should hedge its bets by getting stock warrants — a certificate giving the holder the right to purchase stock in the future at a guaranteed price — equal to a significant percentage of each good bank’s common equity (although certainly not a majority share).

After all, assuming the good bank/bad bank asset transfers were successful, the stock prices of the good banks are likely to soar, as they will be the four best capitalized and cleanest banks in the world. The government, in turn, could sell the warrants to private parties, another bonus for taxpayers. And as those private investors exercised the warrants, they would infuse even more common equity capital into the banks, which is of course what they really need.


With a clean balance sheet and the best capital ratios in the world, the resulting good banks - still under majority private ownership - could get back to doing what our economy most desperately needs from them: start making new loans.

Max Holmes is an adjunct professor of finance at the Stern Graduate School of Business at New York University and the chief investment officer of an asset management firm.

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Why government guarantees are a double-edged sword, by Viral V Acharya and Julian Franks

As the search goes on for culprits and remedies in the global financial crisis, not enough attention has focused on the role played by governments in explicitly or implicitly guaranteeing the banking system. The massive bank bailouts now being undertaken across the industrial world make the point: governments can not allow banks to fail for fear that the collapse of one will provoke a systemic crisis. By extension, we would contend that government guarantees played a central role in creating the mess in the first place, and that reforming them will be key to preventing a recurrence.

Consider the role played by guarantees in encouraging banks to operate with such astonishingly high levels of leverage prior to the crisis. The market believed that their liabilities – not just customer deposits but also their uninsured public debt - were in effect guaranteed by government regulators. This kept the price of their borrowing artificially low: banks with leverage to assets ratios of 80 or even per cent were able to borrow in the good times at just 20 basis points above government bonds.

The presence of guarantees means that as bank leverage and default risk increase, the true cost to the provider of the guarantee (i.e., the government) rises, but the cost to the bank does not. Hence, banks have a free option to increase leverage to extraordinarily high levels. This would of course not be such a problem if government ‘marked to market’ the price of guarantees, effectively getting banks to pay a fair price commensurate with their risk taking – but that is not how the system works. Compounding the problem, the high leverage that guarantees encourage inevitably leads banks to gamble on expansionary monetary policy by going ‘down the quality curve’.

Of course at some point the low quality loans default, banks make losses and lose a part of their capital. Bank share prices fall reflecting their high leverage ratio and vulnerability to small changes in the value of assets. In turn, uninsured depositors and wholesale creditors start to worry about the likelihood of the government extending guarantees, and the market cost of bank debt spirals upwards.

A case in point here was the bank run at Northern Rock, and the fact that its problems caused a contagion primarily for those banks (Alliance and Leicester, Bradford and Bingley, and HBOS) that had greater reliance on uninsured commercial paper. These banks were accorded higher valuation multiples by markets in good times, but once risks rose, the conditions were reversed. Banks like HSBC that had greater reliance on deposits have been much less affected, and have not even felt the need to participate in the UK government bailout.

Might it be that bankers, by taking on such high leverage, were simply maximizing shareholder value, given there are mispriced government guarantees, and that they simply got unlucky? We do not think so. Instead, we believe that capital budgeting at banks is in fact broken.

First, the relatively flat cost of debt in good times gives bankers the illusion that their cost of capital in bad times will also be low, or in other words, that their funding costs will not rise even with extreme leverage and high business risks.

Second, the extremes of leverage encourage bankers to place little weight on the cost of equity. When leverage is as high as 95% or more and its cost relatively flat, the cost of equity hardly matters. But this is true only until banks find themselves in a crisis and must issue equity at punitive dilution costs.

Third, there is excessive risk-taking at banks also induced by myopic compensation packages tied to the past year’s accounting profits rather than long-term return on assets. No bank board wants to deviate from such packages as it fears losing employees to competitors. It is essentially a “race to the bottom” in the governance of a highly competitive sector.

In absence of guarantees, banks taking on excessive leverage and risks would face steep costs of funding, be it debt or equity. Creditors, for instance, would monitor and discipline bank management in good times rather than leaving that task to regulatory supervision.

Alas, such monitoring largely disappears when so much of bank debt is explicitly or implicitly guaranteed. In the absence of market discipline, deposit insurance and coarsely-designed capital requirements are a most imperfect proxy. The former tend to be mispriced; the latter can easily be gamed.

It is thus ironic that the very guarantees that induced banks to take on excessive leverage and risk, and endanger our jobs and savings, must be sharply increased to get us out of the current mess.

Regulators ought to remind themselves that guarantees are a double-edged sword. They are inevitable in systemic crises, for political reasons as well as for efficiency. But somewhat unfortunately, they linger even after crises abate and their pernicious effects on bankers’ incentives remain unchecked.

The task of fixing capital budgeting at banks is not just for bankers. Only if regulators charge suitably for the guarantees will banks price them in to their loans and leverage decisions. Resolution of the most severe financial crisis of our lifetimes may otherwise soon turn out to be a Pyrrhic victory.


Viral V Acharya is Professor of Finance at the London Business School and New York University Stern School of Business. Julian Franks is Professor of Finance at the London Business School. This article is based on the work undertaken by the authors for Knight Vinke Asset Management and is also forthcoming in The Banker (February 2009).

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Are Bankers Over-Paid? - Thomas Philippon

Employees of the financial industry have enjoyed very high compensation in recent years. The bonuses of Wall Street reached more than $200,000 per employee in 2007. Bonuses fell in 2008 but remain surprinsingly high in light of the industry's dismal performance. So, are bankers over-paid? The history of wages and human capital in the US financial sector turns out to be quite fascinating. Before I spoil the suspense by showing you what actually happened, ask yourself what one should expect. Here are a few hypotheses:

- "Textbook economics" hypothesis: finance has always been a relatively high skill/high pay industry. So financiers have always been more educated and more highly paid than the average worker, and this reflects an efficient allocation of human ressources.

- "Bankers as parasite" hypothesis: finance wages are unrelated to their true contributions to economic prosperity.

- "Stock market" hypothesis: when the stock market goes up, wages in finance go up (why this should be the case remains unclear, however)

- "Computer" hypothesis: all these traders and managers have seen their productivity boosted by computers and IT. This is why they earn so much.

These are just a few extreme hypotheses, and they are not mutually exclusive. It turns out, however, that none of them is quite correct.

Historical Evidence

Ariell Resheff and I have analyzed human capital and wages in the US financial sector over the past century.

Our analysis reveals a set of new facts. First, the relative skill intensity and relative wages of the financial sector exhibit a U-shaped pattern from 1909 to 2006. From 1909 to 1933 the financial sector was a high skill, high wage industry. A dramatic shift occurred during the 1930s: the financial sector rapidly lost its high human capital and its wage premium relative to the rest of the private sector. The decline continued at a more moderate pace from 1950 to 1980. By that time, wages in the financial sector were similar, on average, to wages in the rest of the economy. From 1980 onward, another dramatic shift occurred. The financial sector became once again a high skill/high wage industry. Strikingly, by the end of the sample, relative wages and relative education levels went back almost exactly to their pre-1930s levels.



Using micro data on occupations, we create indices to measure the complexity of the tasks performed by the financial industry. Using this index, we document a similar U-shaped pattern over the past century: financial jobs were relatively more complex and non-routine than non-financial jobs before 1930 and after 1980, but not in the middle of the sample.

We then try to identify the forces responsible for the evolution of human capital in the financial industry.

The fact that relative wages and education in finance were just as high in the 1920s as in the 1990s rules out technology -- in particular information technology -- as the main driving force. There were no computers in private use before 1960. Therefore, the idea that the growth of wages in finance is simply the mechanical consequence of the IT revolution is inconsistent with the historical evidence.

The historical facts also rule out some simple macroeconomic explanations. For instance, the average price/earnings ratio and the ratio of stock market to GDP are not very correlated with the relative wage series. There is a stock market boom in the 1960s, and a collapse after 2001. Overall, the correlation with the relative wage series is small. The same is true of the ratio of trade to GDP.

Our investigation reveals a very tight link between deregulation and human capital in the financial sector. Highly skilled labor left the financial sector in the wake of Depression era regulations, and started flowing back precisely when these regulations were removed. This link holds both for finance as a whole, as well as for subsectors within finance. Along with our relative complexity indices, this suggests that regulation inhibits the ability to exploit the creativity and innovation of educated and skilled workers. Deregulation unleashes creativity and innovation and increases demand for skilled workers.



The second set of forces that appear to have a large influence on the demand for skills in finance are non-financial corporate activities: in particular, IPOs and credit risk. New firms are difficult to value because they are often associated with new technologies or new business models, and also for the obvious reason that they do not have a track record. Similarly, pricing and hedging risky debt is an order of magnitude harder than pricing and hedging government debt. Indeed, we find that increases in aggregate IPO activities and credit risk predict increases in human capital intensity in the financial industry. Computers and information technology also play a role, albeit a more limited one. Contrary to common wisdom, computers cannot account for the evolution of the financial industry. The financial industry of the 1920s appears remarkably similar to the financial industry of the 1990s despite the lack of computers in the early part of the sample.

Are bankers over-paid?

Has financial creativity been over compensated? We construct a benchmark series for the relative wage in finance, controlling for education and employment risk as well as time varying returns to education. Our benchmark wage accounts well for the observed relative wage between 1910 and 1920, and from 1950 to 1990. From the mid-1920s to the mid-1930s, and from the mid-1990s to 2006, however, the compensation of employees in the financial industry appears to be too high to be consistent with a sustainable labor market equilibrium.



Overall, we conclude that bankers were paid about 40% too much in 2006.

Conclusion

In the long run, it appears that the most important factors driving the relative skill demand and relative wages in the financial sector are regulation and corporate finance activity, followed by financial innovation.

Moreover, we show that the nature and timing of regulatory changes point toward a causal role for deregulation and creative destruction in the corporate sector, triggered by technological revolutions.

On the one hand, the change in the relative wage of finance employees is part of an efficient market response to a change in the economic environment. We show in particular that corporate finance needs from the non financial sector help explain the demand for skills in the financial industry.

On the other hand, we find that rents account for 30% to 50% of the wage differentials observed since the late 1990s. In that sense, financiers are overpaid.

Our results have another important implication for regulation. Following the crisis of 1930-1933 and 2007-2008, regulators have been blamed for lax oversight. The Pecora Hearings of 1933 and 1934 documented such lax oversight and made the case for financial regulation; this led to the Glass-Steagall Act, the Securities Act of 1933 and the Securities Exchange Act of 1934. In retrospect, it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation. Given the wage premia that we document, it was impossible for regulators to attract and retain highly-skilled financial workers, because they could not compete with private sector wages. Our approach therefore provides an explanation for regulatory failures. Of course, regulators will be able to hire cheap skilled labor in 2009, just as they were able to in the 1930s.

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Government money should have strings attached - Viral Acharya, David Backus, and Raghu Sundaram

There's a tendency in a crisis to throw out the rulebook: we're in a unique situation, some will say, and that calls for unique measures. In fact, financial crises are recurring events whose history has taught us some clear lessons. One is that policy responses can make things worse if they're not designed carefully. The most important example, we think, is that companies face less pressure to solve their own problems if they think government help is on the way. At best, the cost to taxpayers is higher than it could be. At worst, well-intended policies can aggravate a bad situation.

Consider these examples:

• Lehman Brothers Holdings announced a 13% increase in its dividend and a $100 million share repurchase in January, only to declare bankruptcy in September. CEO Richard Fuld is said to have complained bitterly that the government declined to save Lehman.
• Citigroup paid $5.9 billion in dividends in the first three quarters of the year, only to ask the government for help in November.
• General Motors waited until July to cut its dividend, despite underfunded health-care liabilities and a business with fundamental problems. A public bailout was approved in December.

These are obvious examples, but we can all think of others.
The crux of the problem is that financial institutions as a whole, and even some industrials, seem to be undercapitalized. Until governments invested massive amounts of public money, the world's largest banks had yet to raise even as much new capital as they lost over the last two years. But if the problem is lack of capital, why did these firms (and many others) do the reverse: pay out dividends to investors? It's hard to know their motivation, but easy to imagine that the possibility of government help may have played a role.

So what should governments and central banks do? Consider financial firms. Their lack of capital has generated widespread uncertainty about the solvency of some institutions, which inhibits a broad range of common financial transactions, including interbank loans and commercial paper. Standard policy in such cases is for central banks to supply liquidity to markets, traditionally in the form of collateralized loans, and facilitate the recapitalization of the financial system. Central bank lending traditionally addresses liquidity problems, and new capital, either private or public, addresses solvency problems.

The challenge, of course, is to distinguish illiquidity from shortage of capital or insolvency. The rapid expansion of central bank lending facilities around the world has blurred the line between them. If the two look the same to an outsider, programs designed to increase liquidity can easily have the unintended consequence of inhibiting recapitalization. Why? Because an undercapitalized bank can claim illiquidity to borrow money from a central bank, thereby postponing the necessity of raising more capital. Current shareholders might even prefer this, since recapitalization may come at their expense.

We think private sector arrangements point to improved solutions to both liquidity and solvency problems that governments should consider now. We know it's hard to say that with a straight face right now, but bear with us. Consider liquidity. Many firms sign lines of credit with banks, which give them an option to borrow money at a future date -- under certain conditions. The conditions are important. They typically include restrictions on the use of funds, covenants on financial performance, and a "material adverse change" clause that rules out loans to undercapitalized or insolvent firms. These conditions make it clear that lines of credit are designed to help firms deal with liquidity issues, not solvency issues. An undercapitalized firm can therefore expect that a line of credit will not be honored. These conditions on lending have of course been misunderstood in Illinois, United States where the governor (since arrested and later released) called for a bank to loan money to a bankrupt company so that it could pay severance to its workers!

Central bank lending facilities are, in principle, protected from insolvency by collateral. But the collateral requirements have been loosened so much they have become close to meaningless. There seems to be little in place to stop an insolvent bank from raising cash against shoddy collateral. We think something like a material adverse change clause would be useful here. Central banks should refuse loans to banks, and governments to other firms, that cannot demonstrate their ongoing viability.

Similarly, the private sector has a solution to insolvency; in the US, we call it chapter 11. The government can facilitate this by providing something analogous to "debtor-in-possession" financing, but only in support of a legitimate reorganization of a business that results in a viable company.

Government money shouldn't be a gift to existing investors and management. We think governments need to apply similar terms to the extension of credit: a firm must demonstrate its viability before receiving government money. Without such strings attached, government help is likely to be more expensive and, perversely, reduce the willingness of the private sector to contribute to its own survival. To the extent that firms have already given money away in the form of dividends, there's nothing we can do. But it's in the public interest to establish clear guidelines for the future about the conditions under which private firms can access taxpayer money.

The authors teach at New York University's Stern School of Business. Acharya is also affiliated with the London Business School. Their work is part of the NYU Stern project, “Repairing the US Financial Architecture: An Independent View.”

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Where should the bailout stop? And what to do about GM - Edward Altman and Thomas Philippon

The massive US Government bailout originally intended for the financial industry has now spread to the non-financial sector, and the government is considering bailing out car manufacturers. This is partly the fault of the financial bailout itself, which was badly designed and too generous to the financial industry. Unfortunately, history and political economy have taught us that ad-hoc government interventions to bail out industries are a recipe for long run economic stagnation. This does not mean, however, that the government should stay on the sidelines.

We argue that government interventions should be based on a consistent set of principles because interventions without principles are almost guaranteed to be captured by interest groups, to become excessively politicized, and to be inefficient in the long run. We present four broad principles:

• First, the market failure must be identified;
• Second, the intervention should use efficient tools;
• Third, the costs for the tax payers should be minimized;
• And finally, government intervention should not create moral hazard.

Based on these principles, there is indeed a case for government intervention in favor of GM, but this intervention should not be a give-away bailout.

The market failure that we identify is the disappearance of the debtor-in-possession (DIP) market because of the financial crisis. This provides a rationale for government intervention (first principle). To be efficient, the reorganization should be thorough, and therefore lengthy. This is why it should take place under Chapter 11 of the Bankruptcy Code (second principle). To minimize the costs to the tax payers, the government should provide DIP financing (directly or through private financial institutions) because DIP loans are well protected (third principle). Finally, reorganization in Bankruptcy does not reward bad management and therefore minimizes moral hazard (fourth principle).

We advocate a massive “DIP” loan to GM in bankruptcy. The current bailout plan would offer less of a breathing space to GM and imply more job cuts in the short run than our proposed bankruptcy/DIP financing plan. The DIP loan would allow the restructuring to take place over 18 to 24 months while the bailout would be barely sufficient to avoid liquidation in 2009. To further limit the ripple effects of GM’s bankruptcy, the government should also consider backstopping warranties and spare parts availability, even if the reorganization fails.

Why the bailout would not work

General Motors Corporation originally asked for a $12 billion loan and a $6 billion line of credit to provide the interim financing it said it needs to restructure the company. Under the revised bailout plan passed by the House, GM’s share was reduced to $10 billion. In addition, they plan to be offered a distressed exchange arrangement with their creditors to reduce the amount of debt by as much as $30 billion.

Unfortunately, some form of traditional loan, for $10 billion or even more, is destined to fail in the current environment and will more than likely be followed by additional requests for more rescue funds or a bankruptcy petition once the initial loan has been exhausted. GM’s cash-burn of over $2 billion a month, will reduce its assets even further, and be exhausted three months based on current conditions. The global automobile industry, not just GM, is facing the likely prospect of an extended and severe economic recession. Many economists and financial forecasters expect the recession to last at least another two years with the likely prospect of the worst recession since World War II.

In these conditions, making a bridge loan and offering a credit line to GM is essentially a waste of tax payer money. As we will show, even with a more generous bailout package than the one GM is likely to get, it still will very likely go bankrupt in a year or so.

General Motors’ viability (including its 49% interest in GMAC) can be analyzed in the following way. We take its financial results as of the end of the third quarter of 2008 and estimate its fourth quarter’s operating performance by assuming it was no better, or worse, than that of the third quarter (more likely its fourth quarter’s results will actually be far worse). We also assume a $2 billion per month “cash-burn” for each month in the 4th quarter, as reported by the firm in many of its statements. We adjust its capital structure for the $30 billion reduction in debt and addition to equity based on its proposed massive equity for debt swap. Finally, we assume that GM will receive the $12 billion loan and then a $6 billion line of credit.

Using the 5-variable Z-Score model, as of the end of the third quarter of 2008, GM’s Z-Score was -0.16, which places the firm clearly in the “D” (Default) bond-rating-equivalent category. Indeed, GM’s Z-Score fell and became negative for the first time as of June 2008 and was in the “D” default zone. The average Z-Score of a sample of hundreds of bankrupt firms in the recent past was -0.19. With the pro-forma financial profile as of 12/31/08, GM’s Z-Score improves slightly to -0.09, assuming the receipt of $12 billion in loans and to -0.03 assuming an increase of $18 billion in cash from the government. These scores are still much closer to a “D” rating equivalent than to a “CCC” rating.

In conclusion, even with the generous assumptions as to Q4 operating results and carefully adhering to GM’s own proposed restructuring, GM is still a highly distressed company and likely to go bankrupt, probably with one year.

The DIP solution

We argue that a massive “DIP” loan to GM in bankruptcy will guarantee the firm’s continued existence over an anticipated 18-24 month restructuring period, and the government should also consider backstopping warranties and spare parts availability, even if the reorganization fails. This is far more reassuring than a band-aid $10-12 billion bailout that will not materially reduce the public’s uncertainly about a possible liquidation in 2009.

In addition to the DIP support, bankruptcy status enhances the ability for management to renegotiate existing and legacy pension and health care claims, which is much more difficult outside the protective confines of the court system. Moreover, the savings alone on interest payments by GM/GMAC would be at least equal to the interest of about $3.5 - $5.0 billion a year to the government or its conduit on say a $40 - $50 billion DIP facility.

The government could work with one or more conduit organizations, like JPMorgan Chase, Citi, Wells Fargo, Bank of America and GE, who are experienced in structuring and monitoring DIP loans. DIP loans can be increased over time, with appropriate fees, to sustain GM over the expected long and likely deep recession. We would also advise the US Treasury to encourage institutions that have received TARP subsidies to participate in the DIP loan directly as investors.

What about job losses?

One argument for bailing out GM is simply that the alternative is worse. If GM fails, its employees will become unemployed in the midst of a crisis where the labor market outlook is dismal, and many of its suppliers and dealerships are likely to be liquidated, creating further job losses and economic disruptions.

There is indeed a strong case for helping GM’s employees, but bailing out GM is simply not the solution. First of all, either with the bailout or in bankruptcy, job cuts and reductions in dealerships will be necessary if the firm is to survive. In fact, the current bailout plan would probably offer less of a breathing space to GM and imply more job cuts in the short run than our proposed bankruptcy/DIP financing plan. As we explained earlier, the DIP loan would allow the restructuring to take place over 18 to 24 months while the bailout would be barely sufficient to avoid liquidation in 2009.

In addition, the bailout money does not offer a sustainable solution for GM’s employees. What many employees of the car industry really need is to acquire new skills. Incidentally, a recession is not a bad time to invest in human capital. The money allocated to the proposed bailout would be better spent in vouchers for a massive training program for unemployed workers. This would not only alleviate their sufferings in the short term, but it would also provide them with a better chance of landing a stable job once the economy recovers.

Our proposed solution would also limit the ripple effects of GM’s bankruptcy. The government could backstop warranties and spare parts availability, even if the reorganization fails. This would limit the impact on suppliers and dealerships. Let us also note that concerns about the impact of a bankruptcy on pension benefits are not valid since the well managed GM pension plan under General Motors Asset Management is over-funded (as of mid-December 2008).

In any case, it would be far better for the country and the economy to “right-size” the auto business in the U.S. now and make it more competitive in the long run, rather than have it deteriorate further and sold off at a later date with even more lost jobs and cuts in pension/health care benefits.


Czars and managers

The management and boards of GM, Chrysler and, to a lesser extent Ford, have until recently been in a state of denial. They should now face up to the reality of their dismal outlook, file for bankruptcy, and request the DIP loan. And, if the terms of the loan require changing senior management, so be it. The option to bring in a professional turnaround team is one of the advantages of Chapter 11.

Bailing out GM and Chrysler at the expense of tax payers will only encourage bad management in the future. The plan proposed by the House of Representatives and the White House calls for the appointment of a “car-czar” to oversee the restructuring. Unfortunately, since restructuring proposals will come from existing senior management, it will be difficult for the “czar”, whoever he or she is, to obtain the timely information required to make decisions so critical in a difficult restructuring. Chapter 11 was created precisely to deal with these issues. It would be wise to use it.

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Time to Lift the Veil - Viral V Acharya and Marti G Subrahmanyam

A clearinghouse for credit derivatives trading? The severe stress in the credit derivatives markets since the inception of the sub-prime crisis has been reported in great detail in the financial press. Hitherto arcane CDOs and CDSs (Collateralized Debt Obligations and Credit Default Swaps) have become part of the popular vocabulary. An important aspect of these markets is that these products are traded over-the-counter (OTC) in bilateral transactions between banks and other institutions. In this sense, they are fundamentally different from other financial instruments such as stocks or equity options, which are mainly traded on exchanges. This distinction has many implications, the most important being that relative to exchange trading, OTC markets feature greater counterparty and operational risks as well as lower transparency. Counterparty risk arises from uncertainty about whether one side of the trade will fulfill its obligation in future. Operational risk arises from uncertainty about whether trades will be cleared and settled in an orderly manner by counterparties. Differences in transparency arise from the fact that information about trading volumes and prices is easily available in the case of exchange-traded markets, while in the case of OTC products it is difficult to obtain such data, and hence trading is more opaque.

A case in point is the market for CDS contracts – essentially, insurance products against default risk of companies or sovereigns. Some selective information about the history of this market would serve to illustrate how the differences between OTC markets and exchanges contributed to the broader financial crisis. The CDS market has grown by leaps and bounds since its inception in the mid-1990’s, from around $180 billion in terms of notional amounts outstanding in 1998 to over $50 trillion today. In the early part of this crisis, the fees for purchasing default insurance in this market went up only marginally. However, from mid-February until mid-March of this year, a period during which Bear Stearns’ financial health weakened substantially, the fees for CDS contracts on financial firms widened more than two-fold. For instance, in mid-February, buying protection against the default of Goldman Sachs’ senior unsecured debt for five years cost around 100 basis points annually, but this rose to almost 250 basis points by mid-March. Once the Bear Stearns crisis was resolved through its Fed-brokered sale to JPMorgan Chase, the fee reverted within a month to its mid-February levels. In another such example, the CDS fees on a number of financial firms skyrocketed following the collapse of Lehman Brothers and AIG, reverting sharply only once the rescue packages for banks were announced worldwide. Even companies with pristine credit quality such as GE experienced a huge spurt in their CDS fees to around 600 basis points, and even higher, in recent weeks.

What caused the CDS fees – one of the best market indicators of the credit risk of a firm – to widen so dramatically? Was it just the fact that the financial firms were perceived to be similar to each other, and thus riskier, in the wake of failure of some of their peers? Or was counterparty risk – the risk that the writer of the CDS contract would fail to fulfill its obligations – also an important culprit? It is hard to dispute that large, global financial firms hold correlated portfolios that fluctuate together in value; hence, an increase in the credit risk of one financial firm is generally adverse news about the credit risk of others. But there are also systemic consequences of the failure of a large financial institution, given that such institutions have close ties with each other through a large number of derivative contracts.

Systemic concerns arising from counterparty risk amongst large financial institutions have grown dramatically over the last year, mainly due to the exposures in CDS contracts. Consider the case of Bear Stearns, which was a leading “clearer” of the CDS contracts between financial institutions that trade in these over-the-counter contracts. The imminent failure of Bear sparked fear amongst major financial institutions over the settlement and clearing of these contracts. Since the company was the intermediary in many of these transactions, there was concern that it would be unable to fulfill its obligations on many trades in time, resulting in mark-to-market losses for other institutions. This, in turn, accentuated counterparty risk that was feared to possibly affect orderly trading and settlement of future CDS trades. The lack of adequate transparency in the exposures of different institutions to each other aggravated such fears immensely. Similar fears, which crippled the CDS markets when Lehman Brothers filed for bankruptcy and AIG was tottering on the edge of bankruptcy before being bailed out, are considered largely responsible for the freezing up of inter-bank markets in that period, the effects of which linger to this day. Indeed, many observers feel, with the benefit of hindsight, that it was a mistake to let Lehman fail, since it was a systemically important counterparty, and thus an important part of the global financial “plumbing.”

Given this backdrop, some key questions to answer are the following. Is the over-the-counter nature of these markets responsible for heightened counterparty risk fears? OTC markets have thrived in the financial sector over the past 25 years since the much-celebrated success of the interest-rate swaps market – the market for hedging exposures to fluctuating interest rates. However, the episodes discussed above have shown that OTC markets have several undesirable features, especially during a stressed market situation. But then why don’t participants in these markets privately achieve outcomes that efficiently address these undesirable features? Put another way, why might regulation in the form of centralized clearinghouse or exchanges desirable? There are at least two reasons.

First, all OTC contracts feature collateral or margin requirements, wherein counterparties post a deposit whose aim is to render the contract essentially minimal, near-zero, counterparty risk. The deposit is adjusted daily based on fluctuations in value of the underlying contract (marking to market) and the creditworthiness of the counterparties. The difficulty, however, is that such collateral arrangements are negotiated on a bilateral basis. Parties in each contract do not take full account of the fact that counterparty risk can also affect other players due to lack of adequate transparency about their inter-connectedness. An analogy is useful at this point. It is necessary to have regulations for safety of individual households against fires since each household privately bears the costs of arranging for such safety but its benefits accrue to the entire neighborhood. Similarly, it would be natural to require counterparties with large shares of exposures to post higher collateral requirements. Otherwise, having to unwind these exposures in an abrupt manner, as witnessed in the case of Lehman Brothers and AIG, can put severe price pressure on markets at large. Since OTC markets prevent aggregation of information between trades, they also preclude a ready identification of large exposures in the first place.

Second, the same forces outlined above create resistance from large players to move trading from OTC markets to centralized clearing or exchanges. Large players benefit from the lack of transparency in OTC markets since they “see” more orders and contracts than other players do. They can also unwind their positions more stealthily in OTC markets. And, as noted before, large players would also be required to post higher collateral to clearing houses and exchanges.

In response to these concerns regarding the OTC nature of credit derivatives markets, the Federal Reserve has initiated a move to migrate the clearing of credit default swap contracts through a platform offered jointly by the Chicago Mercantile Exchange and the hedge fund Citadel. The Depository Trust and Clearing Corporation (New York) and LCH.Clearnet Group (London) have announced a merger to create the world’s largest clearing-house, also providing services for OTC products such as interest-rate swaps and credit default swaps. These developments augur well for the credit derivatives market and overall financial stability. The AAA credit rating and risk-management expertise of centralized clearinghouses will help assuage fears over counterparty and operational risks. Centralized clearing will also enable aggregation of trade-level information so that prices, volumes and open interest can be disseminated to market participants beyond the direct participants. Such dissemination would make it possible for regulators to monitor the outstanding positions of a particular institution, and also of a particular contract. And, prices of credit default swaps would reflect what they are supposed to – the credit risk of the underlying entity – rather than that of the counterparty providing the insurance.

Will these initiatives succeed? Some institutions, especially large players, will likely resist calls to move away from the OTC. Hence, the regulatory resolve to do so must be strong. The resisting players must realize (or be informed) that OTC markets can continue to arise whenever the financial sector needs to innovate and customize, but once these markets grow beyond a critical size, they will be required to move to centralized clearinghouses or exchanges. Although we have focused on CDS markets as the proximate example, many other markets that have figured prominently in the current crisis, most notably those trading mortgage-backed securities, collateralized debt obligations (CDOs), and asset-backed commercial paper, have also experienced severe stress. Fundamentally, there is no reason why these products cannot be traded and cleared more centrally.

It is high time to lift the veil of opacity of bank balance sheets and inter-bank linkages, starting with more transparent and centralized platforms for credit derivatives trading.

Viral V Acharya is Professor of Finance at the London Business School and the Stern School of Business, New York University. Marti G. Subrahmanyam is the Charles E. Merrill Professor of Finance, Economics and International Business at the Stern School of Business, New York University.

This article appeared as op-ed at Forbes.com on 12 Nov, 2008:
http://www.forbes.com/home/2008/11/12/credit-derivatives-trading-oped-cx_va_1113acharya.html

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Citi, Goldman, Too-Big-to-Fails, Need New Rules - Roy C. Smith

Nov. 10 (Bloomberg) -- Federal Reserve Chairman Ben Bernanke recently told the Economic Club of New York that the U.S. faces “a very serious too-big-to-fail problem.” As Bernanke described it, this means that the insolvency of one large company could threaten the global financial system. “There are too many firms that are, in some sense, systematically critical,” he said. He knew this, of course, because the world financial system did collapse, or came pretty close.

About the same time that Bernanke spoke, a summit of the European Union, which had pledged more than $2 trillion to rescue banks, included a call from U.K. Prime Minister Gordon Brown for a restoration of the 1944 Bretton Woods Agreement. By this, he meant a globally coordinated effort to impose more stringent regulation on financial companies to avoid the excesses that plunge the world into economic turmoil every few years.

The stirring about an overhaul of the global financial system is likely to get more attention once President-elect Barack Obama takes office and a new economic team is appointed. The danger seems to be that the process will become either overly politicized or rely too much on the public sector to control financial markets.

Neither would be good. But we must recognize that taxpayers, who are guaranteeing the liabilities of so many banks, insurers and securities firms, have a right to be at the bargaining table when a regulatory system is established. It’s not too early to think about a framework for what a new financial regulatory system must do, and how it would perform. Here are a few components of the framework:

Global Rules

1. Any new system will need to be global, so the nations that have adopted the Basel Accord, hosted by the Bank for International Settlements in Switzerland, would be a good place to begin. The first Basel agreement in 1988, however, applied only to commercial banks and focused on bank-capital adequacy. The Basel system hasn’t served us well because it didn’t fully account for sudden losses of market liquidity. Plus, it was too tolerant of risks collateralized by mortgages and other assets.

Basel II, which went into effect in 2004, needs to be set aside in the immediate search for a replacement, which will have to address the shortcomings of the system that failed.

2. As Bernanke said, there are many large financial companies whose failure might place the entire system at risk. All of them -- such as Goldman Sachs Groups Inc., Citigroup Inc., HSBC Holdings Plc and UBS AG -- need to be included within the purview of a new, beefed-up regulatory framework.

Broader Definition

Banks, thrifts, investment banks, insurance companies, hedge funds and asset-management groups must be included if they are judged too big to fail -- those companies with $1 trillion or more in assets and that trade in global capital markets. There will be resistance from such companies, about 30 to 40 in all, but it must be done by all countries subscribing to the system.

3. Regulators need to agree on what they want to regulate: This should be all forms of risks that might threaten a company. The system will need to look at all risks that the regulators regard as appropriate, and they must do so on a forward-looking basis using forecasts and projections.

4. Risks to monitor should include inadequacy of controls, excessive growth, compensation systems, asset concentration and leverage. These should be measured by a common accounting system that offers little wiggle room for determining reported asset values, and that severely limits off-balance-sheet parking of assets or contingent liabilities.

More Power

5. National regulators must have greater authority to block acquisitions and limit growth and leverage if they believe these increase a company’s systemic-risk potential. This would be a judgment call by the regulator on the scene, which could be appealed to a regulator-in-chief. The power of the regulators to blow the whistle on individual companies must be asserted and defended. This was the case 20 years ago when U.S. commercial banks were last in crisis.

6. The regulator-in-chief must be a new entity that supplements existing regulators, and include professionals from federal banking authorities, the Securities and Exchange Commission and the Commodity Futures Trading Commission. Its job would be only to regulate too-big-to-fail companies.

Many large financial companies might object to what they regard as harsh regulations. But there is a new business model available that might prove to be better and more durable than the one they have followed for years.

This new model would provide a large, stable market share, cheap funding, and opportunities for full use of technology to lower operating costs. Companies could offer investors steady growth, less risk and perhaps higher dividends. As a bonus, they might even offer the higher returns generated by investment banking, trading or proprietary investment through units that could be spun off to shareholders.

Other banks might escape the tougher regulation by shrinking or breaking up into smaller enterprises with assets of less than $1 trillion, gaining more freedom to operate with less-stringent regulation.

It seems a fair choice.

Roy C. Smith, co-author of “Global Banking,” is a finance professor at New York University’s Stern School of Business. The opinions expressed are his own.

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Should GM/Chrysler File for Bankruptcy? - Edward I. Altman

All this talk about a government rescue of General Motors and other automakers is misguided, likely a waste of taxpayers' money and a potential further diminution in the creditworthiness of the U.S. government. It is time, instead, to focus seriously on the gut-wrenching question of whether this American icon should file for bankruptcy as soon as possible--or continue attempting to survive outside the protective confines of the Bankruptcy Courts.

With GM's financial profile--based on my "Z-Score" bankruptcy-prediction model--now clearly deep into the distressed-firm zone and with the global economy facing a severe and likely prolonged economic recession, the correct choice is to file for bankruptcy and seek an immediate significant liquidity boost from the post-bankruptcy debtor-in-possession (DIP) financing mechanism. This traditional option for failing companies will require a unique twist: assistance of the U.S. government as a meaningful player, but at little risk and attractive returns to the U.S. taxpayer.

The latest chapter in this continuing debate is that the current administration in Washington will likely honor its commitment to provide $25 billion in low-interest loans to the major U.S. auto manufacturers for the development of fuel-efficient cars. And there is mounting sentiment in Congress and within the president-elect's transition team to provide even more assistance.

The fuel-efficient-car component requires, however, that the Energy Department conclude that the borrower has assets that exceed its liabilities and that it is likely to be able to repay the loans. As of Sept. 30, however, GM had total assets of $110 billion but liabilities of $170 billion. GM must somehow convince Energy officials that it is solvent and creditworthy, a dubious possibility now that it has announced it will run out of cash by mid-2009 and will violate loan covenants on about $6 billion in debt very shortly.

Unless it secures new sources of capital--or the government infusion is in the form of equity--GM's liabilities will still exceed its assets. Unfortunately, some form of traditional loan guarantee or outright investment in the combined GM/Chrysler entity is destined to fail and be followed by repeated requests for more rescue funds.

As noted, these companies are facing the likely prospect of an extended, severe economic recession, not to mention the staggering weight of their own inefficiencies, huge pension and health care benefit packages, and their clear bankrupt profiles. The latter is based on GM's Z-Score of -0.17 as of September 2008--clearer in the case of GM, since Chrysler's financials are not available since it is a private company. If the government does increase the loan program for more fuel-efficient cars, GM will still need substantial interim support until any tangible benefits from this subsidy are observable.

Now comes the tricky part: What is the alternative to a highly controversial government bailout? If it were not for the potential panicked reaction in global credit and automotive markets, the answer would be clear. Both GM and Chrysler should file for protection--yes, protection-- under the U.S. Bankruptcy Code, as soon as feasible. The enormous benefits afforded to companies whose assets are protected and whose fixed payments on most liabilities are suspended, while attempting to reorganize under Chapter 11 of the Code, are clear. And another, sometimes overlooked, benefit for companies in bankruptcy is their ability to borrow substantial amounts of funds for continued operations under what is known as DIP financing.

This unique aspect of our Bankruptcy Code gives the provider of funds a super-priority status over all existing unsecured claims, and is almost always accompanied by specific collateral, since the chance of losing any of its investment is quite remote. Indeed, the number of DIP losses to lenders can be counted on one hand from the thousands of such financings in the past. GM (and probably Chrysler) still has some unencumbered assets to qualify, and even if it did not, the super-priority status gives the new lender a greater degree of confidence of being repaid.

Ford Motor has less of these unencumbered assets, although its Z-Score is somewhat higher than GM. Critics of this idea will quickly point out that the current market for DIP lending is essentially shut down, as financial institutions are in a massive deleveraging phase and DIP risk capital, even at spreads of 700-800 bps (7%-8%) over London Interbank Offered Rate, is currently unavailable. Circuit City's $1.1 billion DIP facility did, however, show some life in the DIP market. Because of this, the DIP lender of last resort is, and should be, the U.S. government. Better that than than allowing our vehicle production industry to be sold off to foreign interests.

I advocate that the government work with one or more conduit organizations, perhaps by merely providing a loan guarantee, like JPMorgan Chase, Citigroup, Wells Fargo and GE, who are experienced in structuring and monitoring DIP loans.

These loans can be increased over time, with appropriate fees, to sustain GM over this expected long and likely deep recession. Without this support, GM and Chrysler are, I am afraid, doomed to eventually file for bankruptcy at a later point, with lower recoveries as asset values deteriorate and job losses mount. Indeed, Chrysler has already announced that 50% of its workforce would have been laid-off if the two companies had merged.

In addition to the DIP support, bankruptcy status enhances the ability for management to renegotiate existing and legacy pension and health care claims, which is much more difficult outside the protective confines of the court system. And the savings alone on interest payments by GM and GMAC would be at least $16 billion a year, easily covering the interest of about $3.5 billion to $5 billion a year to the government or its conduit on, say, a $50 billion DIP facility.

Some fear that a GM bankruptcy announcement will cause immeasurable harm to the economy and to financial markets. The current situation of "waiting for another shoe to drop" in the credit market meltdown includes a possible GM-Chrysler bankruptcy filing--and no doubt there will be some negative consumer and vendor fallout should they file.

But pointing out the high likelihood of bankruptcy, something that I and the credit-default swap market have been forecasting for some time, will help reduce the surprise impact. And the indication of guaranteed government support via the post-bankruptcy DIP financing route could help blunt consumer fears of liquidation, lost warranties, spare-parts availability and other bankruptcy costs that the management and board of GM worry about. Face it, those costs, in the form of lost sales and profits, have already mostly taken place as potential customers assess the health of the major auto companies in their purchase decisions.

The management and boards of these two companies, which have been in a state of denial, should face up to the reality of their dismal outlook and request the DIP loan, leaving the government the choice of supporting this unusual rescue, concluding that it would be far better for the country and the economy to "right-size" the auto business in the U.S. now and make it more competitive, rather than have it deteriorate further and sold off at a later date with even more lost jobs and cuts in pension and health care benefits.

Nobody wants to see our American motor carrier icons go into bankruptcy--not even me and others who have been predicting this fate for some time. But, if most stakeholders will be better off and if we can minimize the surprise factor, then Chapter 11 reorganization (not liquidation) with government-sponsored DIP lending is the way to go.

Edward I. Altman is the Max L. Heine Professor of Finance at the Salomon Center at New York University's Stern School of Business and Director of the Center's Research Program in Credit and Debt Markets. He is the creator of the Z-Score method for assessing the financial health of companies.

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One cheer for the Securities and Exchange Commission - Joel Hasbrouck

The Securities and Exchange Commission has come under much criticism in the current financial crisis. Many of the problems have indeed arisen in its bailiwick. It was the principal regulator of Bear Stearns and Lehman. It designates and oversees “Nationally Recognized Statistical Rating Organizations,” more commonly known as credit ratings agencies. Though it delegates lot of its authority, it is ultimately in charge of financial reporting for all corporations, and can in principle compel disclosure of terms of swaps and other derivatives on a firm’s balance sheet. The SEC’s mandate prominently features investor protection. Given the large government transfers to private interests, it appears that the investor most in need of protection was the US taxpayer.

These problems, though, should not prevent us from recognizing the accomplishments of the SEC in other areas. The SEC oversees and regulates the trading mechanisms in US stock and bond markets, including the New York Stock Exchange and Nasdaq. In the crash of 1987 these mechanisms failed. NYSE systems were overwhelmed. Orders were submitted, but then it couldn’t be determined whether they had been executed. Investors didn’t know whether a trade price they saw on the tape was one second or one hour old. Many Nasdaq dealers avoided their market-making responsibilities by simply not answering the phone.

Recent days have been marked by unprecedented volume and volatility. The trading mechanisms have nevertheless functioned smoothly. Although many stocks have declined in value, these declines seem to arise directly from the interaction of investor supply and demand. The losses have been attributed to many causes, but nobody has seriously blamed the trading procedures.

Market mechanisms have evolved significantly since 1987. This evolution was not inevitable, and the SEC played a major role in facilitating it. The SEC was an active enforcer during this period, under both Democratic and Republican administrations. It brought a broad array of charges against Nasdaq dealers, and later against NYSE specialists. In both cases the SEC pursued wrong-doing, but it also leveraged its power to compel reform. Most importantly the SEC established a legal and regulatory framework for US equity markets to morph from crowded trading floors to fast and efficient electronic markets. In 1998 the SEC put forth a regulation allowing “Alternative Trading Systems” There followed a great wave of innovation in market design. Later, concerned with the coordination problems that might arise among markets separated by physical or virtual barriers, the SEC adopted “Reg NMS” (National Market System). This rule established a framework requiring markets to share information and provide access.

In bond markets, the SEC fought an uphill battle against entrenched industry interests to establish last-sale reporting in corporate bond markets. The TRACE system (for Trade Reporting and Compliance Engine) now gives investors of all sizes prompt reports of the prices and sizes of recent trades.

Many of these successful initiatives sprang from crises. US stock and bond markets have emerged from this period lean, efficient and internationally competitive. There is no reason why the present crisis cannot serve as a similar starting point. Our recent experience is being cast as the failure of financial markets. The facts, though, are likely to defy such a simple characterization. As we undertake the process of investigation, accusation, recrimination, and (ultimately) reform, we should be guided not just by what went wrong, but also by what went right.

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Assessing Proposed Solutions to Bias in Credit Ratings - Vasiliki Skreta and Laura Veldkamp

Most market observers attribute the recent credit crunch to a confluence of factors: lax screening by mortgage originators, improperly estimated correlation between bundled assets, market-distorting regulations, and a bubble in financial services. In addition, most agree that inflated credit ratings played an important role in facilitating the market exuberance leading up to the crash. This leaves many policy makers asking what laws might prevent ratings bias in the future. To answer this question, it is important to understand the sources of ratings bias.

One argument about the source of ratings bias focuses on asset issuers who shop around for the highest ratings. Former chief of Moody's, Tom McGuire, explains to the New York Times Magazine, (April 27, 2008):

• “The banks pay only if [the ratings agency] delivers the desired rating. … If Moody's and a client bank don't see eye-to-eye, the bank can either tweak the numbers or try its luck with a competitor like S&P, a process known as “ratings shopping.”

While the issuer-initiated ratings system has been around since the 1970's, ratings bias only recently emerged as a concern. To argue that it took 30 years to detect the bias is to suggest that learning by financial market participants is unrealistically slow. This raises the question: Is it possible that ratings shopping previously had no or a small effect and that something about the credit market changed to amplify its effect?

A second argument about why credit derivatives were mis-rated attributes the problem to the increasing complexity of assets. As Mark Adelson testified to the Committee on Financial Services, U.S. House of Representatives, (September 27, 2007)

• “The complexity of a typical securitization is far above that of traditional bonds. It is above the level at which the creation of the methodology can rely solely on mathematical manipulations. Despite the outward simplicity of credit ratings, the inherent complexity of credit risk in many securitizations means that reasonable professionals starting with the same facts can reasonably reach different conclusions.”

However, this explains why ratings were less accurate, not by they were systematically too high. This raises the question: Is it possible that more dispersion in ratings can translate into higher ratings on average?

While neither of these two arguments alone explains why ratings bias arose in the mid-2000’s, taken together, they offer a coherent story. Suppose ratings agencies each issue an unbiased forecast of an asset's value. Issuers have the strongest incentives to shop when ratings across agencies are most dispersed. For simple assets, all of the agencies are likely to issue nearly identical forecasts; if there is little difference in forecasts, then looking for the best one is not worth the cost. Conversely, complex assets are hard to rate, so ratings agencies may differ in their assessments, creating an incentive to shop for ratings. Once issuers engage in ratings shopping, they want to structure their assets to make them even more complex and harder to rate to get a broader menu of ratings to choose from, making ratings shopping even more valuable. Thus, already complex mortgages and bonds were pooled and tranched and turned into CDO’s (or CMO’s), then CDO’s of CDO’s and eventually CDO’s-cubed. If mortgage-backed securities were initially more difficult to accurately rate than other pre-existing asset classes, it could trigger a cycle of more complex assets and more biased ratings. If a default shock arrives and reveals to investors that ratings are biased, asset prices will fall, creating the crisis we observed last August.

Perhaps the most popular argument about the origin of ratings bias is that ratings agencies were not each constructing unbiased forecasts of assets’ values. Because they were being paid by the asset issuers, they had an incentive to manipulate the data to come up with the most favorable possible rating, in order to attract more business. While this may or may not have taken place, reforms which only remedy this conflict of interest problem may fail. The scenario above shows how even without any ratings agency complicity, bias can still arise.

In June 2008, New York Attorney General Andrew Cuomo negotiated an agreement with ratings agencies that required them to disclose information about assets that were submitted for initial review but that were ultimately rated by another agency. In theory, such mandatory disclosure prevents ratings shopping. But in practice, this is not difficult to circumvent: When undesirable ratings are proposed, the issuer just makes small changes in the asset’s structure. Because this is now a new asset, the previous rating is no longer applicable and is effectively hidden.

Other reform proposals call for more competition in the ratings market. This too may be misguided. If ratings shopping is one of the sources of ratings bias, then increasing the number of ratings agencies only broadens the menu of ratings to shop from. If an asset issuer always chooses the highest available rating, then broadening the menu or ratings to choose from is likely to make the highest available rating even higher. In this case, more competition could result in even more bias.

One solution to ratings shopping is to prohibit asset issuers from paying ratings agencies and require the investors who purchase the credit assets to foot the bill. The pitfall of this approach is that many assets may not be rated if investors are unwilling to bear the cost. The problem is exacerbated if investors try to free-ride on others’ information purchases. For example, one investor may decide not to purchase a rating reasoning that he’ll let another investor pay for the rating and then watch how the other investor trades to infer whether the information he observed was positive or negative. If all investors reason this way, no one will be willing to buy the rating. Thus the choice between the current ratings system and one where investors initiate ratings may come down to the all-too-familiar choice between quantity and quality.

It is possible that all this talk about conflict of interest and ratings shopping has made investors more savvy than they used to be. Perhaps now investors can mentally undo the bias built into ratings when they price assets. If this is the case and everyone understands that what used to be a B is now an A, then ratings bias has become innocuous and we should simply let the current system stand.

Please click the following link for the complete paper. Ratings Shopping and Asset Complexity: A Theory of Ratings Bias

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Forecasting Default Rates: A Tricky Business - Edward I. Altman

In this paper, we introduce two new market based methods for estimating the one year hence default rate on high-yield corporate bonds. Observing our two market-based measures for forecasting default rates for September 30, 2009, we see estimates between 8.57% and 11.18%. No doubt, the market-based approaches imply that investors expect a stressed economic and credit market scenario over the next 12 months and a resulting relatively high default rate.

As noted in our Annual Reports, we utilize our mortality rate model to forecast the next year’s default rate and we only do this at one point in the year - - January. This forecast is “recession-neutral” in that it is based on the historical incidence of default from almost 40 years of experience covering five recessions and over 30 years of non-recession growth in the US economy. As such, it does not explicitly consider the macroeconomic outlook.

Please click the following link for the complete paper.Forecasting Default Rates

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The other part of the bailout: Pricing and evaluating the US and UK loan guarantees - Viral V. Acharya and Raghu Sundaram

Apart from taking equity stakes in selected financial institutions, the recent attempts to thaw financial markets also involve government guarantees on newly-issued senior unsecured debt of banks, an aspect that has received considerably less attention than the recapitalization and part-nationalization of banks. The guarantee schemes announced by the US and the UK are strikingly different in terms of which banks are covered, the optionalities they offer to the banks concerning protection, and, not least, the fees charged for this protection. We describe the two schemes in detail, analyze their features and discuss the outcomes likely to arise under each. Among other things, we find that while the UK scheme will break even (or perhaps even net a small profit to the UK Treasury), the US scheme involves, on a fair value basis, a huge cost to the taxpayer of upto $50 billion over the three-year horizon of the scheme.

Introduction

On either side of the Atlantic, the attempt to thaw the frozen credit markets has taken a two-pronged approach. On the one hand, the US and the UK (and some European) governments are re-capitalizing their troubled financial institutions by taking preferred equity stakes in them. On the other, to kick-start the interbank lending markets, they have announced plans to guarantee all new senior unsecured debt out to 3 years. The first of these actions has received plenty of attention and discussion, but the second has largely passed under the radar despite the huge sums of money involved (the amount of debt insured in the US alone could easily surpass the volume of demand deposits held in US banks).

What are the costs to taxpayers of the announced guarantees? Indeed, are they costs in the first place? What are the relative merits of the US and the UK schemes?

The Guarantee Schemes Described

First, some details concerning the schemes.

In the UK, nine financial institutions have been identified as initially eligible for the program (though more may be added later at the discretion of the UK Treasury). Senior unsecured borrowings of these institutions made on or prior to April 13, 2009 will be guaranteed by the UK government for a period of 3 years or maturity of the issue, whichever comes first. Participation in the program is optional, not just at the institutional level, but also at the issue level; that is, a prospective borrower wishing to issue a “Guaranteed Liability” applies to the UK government for a guarantee on that particular issue. Limits on the total volume of guarantees that may be sought by any one institution have not been laid out explicitly, though the UK Treasury has announced a cap of GBP 250 billion as the maximum amount of liabilities that will be guaranteed under the scheme.

The US program, administered by the FDIC, works very differently. All banks, depository institutions, and savings and loan companies are eligible to participate in the program. Institutions not wishing to participate in the program must inform the FDIC by November 12, 2008, of that decision. If an institution does not opt out of the program, then all senior unsecured loans issued by it between October 14, 2008 and June 30, 2009, will be guaranteed by the FDIC for a maximum period of three years or until maturity of the debt, whichever comes first. The only exception is if a participating institution informs the FDIC (again prior to November 12, 2008) of its desire to also issue during this period non-guaranteed long-term debt maturing after June 30, 2012, in which case the guarantee applies to all new senior unsecured issues except these long-term issues. The maximum amount of liabilities issued by a single institution that will be guaranteed by the FDIC is 125% of the outstanding senior unsecured liabilities of the institution as of September 30, 2008; but unlike the UK, no cap has so far been proposed on the overall liabilities that will be guaranteed under the plan.

The Fees

Unsurprisingly, given the differences in the schemes, the pricing of the guarantees in the two countries is also along very different lines.

In the UK, an institution seeking a guarantee on an issue will be charged an annual fee of 50 basis points plus that institution’s median 5-year credit-default swap spread observed in the 12 months preceding October 7, 2008.

As an example, on October 21, 2008, Barclays decided to issue GBP 1 billion in 3-year senior unsecured bonds backed by the UK government’s guarantee. Since Barclays’ median 5-year CDS spread over the 12 months to October 7, 2008, was around 82 basis points, this means Barclays will be paying the UK Treasury a figure of 1.32% — about GBP 13.2 million — per annum for the guarantee. A few days earlier, on October 17, taking advantage of the issue-level optionality available in the UK scheme, Lloyd’s TSB elected to issue a GBP 400 million debt issue without seeking a guarantee. Lloyd’s median CDS spread during the relevant period was only 62 basis points, among the lowest of any UK or US financial institution.

In the US, each participating institution will pay a flat 75 basis points per annum on the entire amount of its new senior unsecured liabilities (subject to the 125% cap mentioned above); if the institution has informed the FDIC of its intent to also issue non-guaranteed long-term debt, then the 75 basis points fee applies to the guaranteed portion of its new debt issues. But in the latter case, the institution must also pay a one-time fee of 37.5 basis points of that portion of its senior unsecured liabilities as of September 30, 2008, that will mature on or before June 30, 2009.

So, for example, under the US scheme, both Morgan Stanley—whose median five-year CDS spread during the 12-month period ending October 7, 2008, was over 159 basis points—and Bank of America—whose median spread at 85 basis points was among the lowest of any major US bank—would both pay the same fee of 0.75% (about $7.50 million per year on a $1 billion guaranteed issue) despite the large difference in their market-perceived credit risks.

Question 1: Tax or Subsidy?

Table 1 (available at http://www.voxeu.org/index.php?q=node/2487) presents information on the median 5-year CDS spreads on the eligible British banks over the one-year period expiring October 7 2008. Even a casual glance at these numbers suggests that the British Treasury’s fees for providing the guarantee, which vary between 109 basis points for HSBC at the low end to over 178 basis points for Nationwide, are a great deal higher than the proposed American flat fee structure. Are the British fees too steep—effectively levying a tax on participating banks—or is it that the American fees are too low, with the taxpayer subsidizing the banks?

Providing a meaningful answer to this question requires identifying a benchmark “fair price” of a three-year sovereign guarantee (see footnote 2). The market price of a similar three-year guarantee is a useful place to begin. That market price would be the spread on a 3-year CDS. However, this market price represents a private, not sovereign, guarantee, and so is of lower quality. Using this approach will result in numbers that are possibly too generous to the banks. An alternative is to compensate for this undervaluation by adding the three-year swap spread (see footnote 3) to the three-year CDS spread. As a third option, to account for potential liquidity effects that may widen the swap spread but have nothing to do with credit risk, we can take the mid-point of the first two estimates. We compare the fees below under all three alternatives.

Alternative 1 The first alternative we consider is where the fair value of the government guarantee is estimated as the market value of the three-year CDS spread plus the three-year swap spread. The three-year swap spread over the last year has been on average around 90 basis points in both the US and the UK. For the 3-year CDS spread, we take the median value of the 3-year CDS spreads over the 12 months ending October 7, 2008. We note that these median spreads are well below the spreads prevailing in recent days (see, for example, the last two columns of Table 1 that describe CDS spreads as of October 10, 2008). The fourth column of Table 1 describes the resulting fair values by financial institution in the UK and the US.

Consider the UK numbers first. The average guarantee fee over all eligible institutions works out to 133.7 basis points, whereas the average fair price works out to 160.8 basis points. This means an average subsidy of 27 basis points per year. If the entire available guarantee amount of GBP 250 billion is taken up, the resulting subsidy to be borne by UK taxpayers is of the order of about GBP 0.675 billion per year, or about GBP 2 billion over the three years of the scheme. The figure will be higher if the stronger banks opt out of the scheme, but even if only the four weakest banks participate in the scheme, the subsidy estimate rises to only about GBP 3.4 billion.

The US numbers are of a different order altogether. The guarantee fee for all institutions is 75 basis points, while the average fair price works out to almost 120 basis points higher at 194.9 basis points. Assuming a total guarantee figure of $1.5 trillion (an estimate that is likely on the lower side), this means an annual government subsidy to the participating banks of $18 billion, or well over $50 billion over the three years of the scheme.

Alternative 2 What if we take a very generous (to the banks) approach and use the unadjusted 3-year CDS spread to represent the fair value of the guarantee? In this case, the average CDS spread for UK banks is around 70.8 basis points, about 63 basis points less than the average fee of 133.7 basis points. In this case, the UK fee represents a tax on participating banks that amounts, over the three years of the scheme, to over GBP 4.5 billion. If only the four weakest banks participate, then the tax figure falls to about GBP 3.3 billion.

But even if we use the unadjusted three-year CDS spreads for the US banks, a substantial subsidy remains. The average three-year CDS spread works out to 104.9 basis points against the fee of 75 basis points. This means a subsidy of 30 basis points per guaranteed dollar per annum, or about $13 billion over three years on a guaranteed principal amount of $1.5 trillion.

Alternative 3 As a final computation, we take the mid-point of the two earlier estimates. The cost of the guarantee scheme to UK taxpayers ranges between a low estimate of –GBP 4.5 billion and a high estimate of +GBP 2 billion. Averaging these estimates results in a figure of –GBP 1.25 billion, i.e., in a tax on the banks of about GBP 1.25 billion. If only the four weakest banks participate, then these low and high estimates become -GBP 3.4 billion and +GBP 3.3 billion, for an average cost near zero, meaning the scheme breaks even.

The high and low estimates for the US are, however, $13 billion and $54 billion, so even the average of these numbers leaves US taxpayers with a bill of over $30 billion over the three-year period.

Question 2: Optional Participation and Pooling/Separating Outcomes

As we have noted earlier, the US and UK schemes have very different optionality features for the participating banks. What are the implications of these differences for take-up of loan guarantees and easing of inter-bank lending and other credit markets?

The UK scheme is likely to lead to what economists like to think of as a separating equilibrium. Banks (with some hindsight, HSBC and Lloyds TSB) whose credit risk is lower than the market’s perceptions can opt out since the loan guarantee scheme provides them little subsidy relative to the fair price for guaranteeing their debt (and potentially imposes a cost). Too, there is no cost to opting out. In contrast, banks whose credit risk is worse than market’s perceptions would find it costly to opt out and thus avail of the scheme. This separation will reveal to the markets which banks are healthy and which are not. It should be noted that the UK capital injection scheme has similar features too: it allows healthy institutions to opt out of accepting government infusion, and indeed HSBC, has opted out there as well.

In contrast, the US loan guarantee scheme will force a pooling outcome wherein all banks within the eligible set – regardless of their health – will participate because it is not possible to re-enter later should conditions worsen and capital become even harder to access. To this stick is attached the carrot of guarantee rates that seem to be heavily subsidized relative to fair price. As an aside, we note that the US capital infusion plan too involved such pooling, with none of the nine eligible institutions allowed to opt out.

One would expect that in either case, government guarantees of bank debt should boost inter-bank lending in the near future. The question really is whether they will thaw markets sufficiently that the guarantees are not relied upon any further. On this front, the separating and pooling outcomes have sharply differing implications.

By revealing healthy banks from the pool, the separating outcome enables banks and markets to provide credit at prices that more accurately reflect the credit risk of counterparties. Such pricing of credit risk is also an important step in ensuring lending markets continue to function in an orderly manner once guarantees are removed. Separation also enables healthy banks to signal their quality to other banks and markets, making it costly for the unhealthy ones to raise debt and equity capital in future. Thus, the UK scheme, by design or coincidence, aims to achieve a market-style outcome at little cost to taxpayers (and possibly even at negative cost). All this is to the good.

The pooling outcome, in contrast, may keep the system reliant on government guarantees for a longer period since it does not facilitate a better pricing by banks and markets of individual banks’ credit risk. It effectively gets healthy banks to subsidize the borrowing of unhealthy ones and does not impair capital-raising ability of the latter. The scheme is best characterized as a bailout that transfers taxpayer funds to the banking sector.

But might the UK scheme end up being too harsh under some scenario? The answer is: it depends, in this case on the evolution of the financial crisis over next several months.

The UK scheme implicitly relies on the assumption that following the recent capital infusions, even the unhealthy players are now solvent to a point that they are simply unlikely to fail in foreseeable future. If the financial crisis deepens further, due to global macroeconomic woes or revelation of more losses linked to imprudent lending, this assumption may fail. Under this pessimistic scenario, the unhealthy banks, having been separated out, will find it more difficult to issue capital and/or borrow and potentially fail. The inter-connectedness of banks may transform a significant bank failure, through contagion risk, into a systemic crisis that once again causes credit markets to freeze. And, the unhealthy banks, that took the government recapitalization and loan guarantees, will be forced to rely even more on taxpayer money. That is, the strength of the UK scheme – its attempting to achieve a market-style outcome – could end up being its Achilles’ heel in case of further market stress. In contrast, the US scheme, by being a government bailout, has the one virtue in that it will ensure smoother tiding over such stress in future.

Conclusion

How should governments assist banks during a severe systemic crisis: in the UK style that uses market information in its operation and looks to separate healthy and unhealthy institutions, or in the US one-solution-fits-all style? The answer is not unambiguous. The only clear picture that emerges at this stage is that the US and the UK schemes – both part of a globally coordinated rescue plan – in fact sit at opposite extremes, one with the flavor of a subsidy, the other laden with a tax; one partly market-reliant, the other almost fully government-reliant. Which one will emerge better? We will be able to tell only once we gauge the depth of looming recessions.

Footnotes

1. Viral V. Acharya is Professor of Finance at the London Business School and Stern School of Business, New York University. Raghu Sundaram is Professor of Finance at the Stern School of Business, New York University. Their respective e-mail addresses are vacharya@stern.nyu.edu and rsundara@stern.nyu.edu.

2. We are in unchartered territory here since there is no history of sovereigns writing default protection on market issues of debt and pricing these off market quotes. The numbers we describe in this analysis should therefore be taken as indicative amounts rather than literally.

3. Roughly speaking, the three-year swap spread measures the difference between the three-year borrowing rates of a AA-rated institution and the Treasury in each country, and so is a measure of the difference in credit quality of the sovereign and the “best” private borrowers. However, the greater liquidity of Treasuries may also widen the spread, so some portion of the spread may be due to liquidity factors.

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